Risk management contracts and method and apparatus for trading same

ABSTRACT

Provided herein are various exemplary methods and apparatus for implementation of futures securities custom tailored to specific clienteles; one or more variable pay-out futures contracts as devices for hedging; hedging contracts having variable pay-outs; variable payout hedging contracts having limited exposure; freezing assets of an originator of an order to buy or sell a variable pay-out contract sufficient to cover a maximum exposure of the contract; determining whether an originator of an order to buy or sell a variable pay-out contract has assets sufficient to cover the contract at the time of placing the order; determining whether an originator of an order to buy or sell a variable pay-out contract has assets sufficient to cover the contract immediately before fulfilling the order and charging a penalty to an originator of an order to buy or sell a variable pay-out contract who does not have assets sufficient to cover the contract.

CROSS-REFERENCE TO RELATED APPLICATIONS

This application relates to technology which is similar to thatdisclosed in published co-pending application Ser. No. 09/923,035, filedAug. 6, 2001 and U.S. Provisional application Ser. No. 60/570,970, filedMay 14, 2004, the entire content of which are hereby incorporated byreference.

FIELD OF THE INVENTION

The present invention relates to a method and apparatus for riskmanagement and to a method and apparatus for establishing andmaintaining a market for initial and secondary trading in riskmanagement instruments. The scope of the invention includes, but is notlimited to: methods of defining risk management instruments, methods oftrading specific types of risk management instruments to manage risk,methods of managing risk, and methods of making a market so that personsmay manage risk by trading in such market.

BACKGROUND OF THE INVENTION

General George Patton is reputed to have once said, “Take calculatedrisks. That is quite different from being rash.” General Patton'sattitudes about risk had far-reaching implications indeed, in that thedecisions he made and the risks he took sometimes cost the lives of menin battle. But the notion of calculated risk goes well beyond warfare;it is a process that we all engage in as we make the daily decisionsthat define our lives. And the fact remains that most of therisks—economic and otherwise—that individuals face in their lives arenot shared by society. As inefficient and insecure as it may seem, “weallow our standards of living to be determined substantially by a gameof chance.”

Over the years a number of instruments have emerged that enable peopleto “hedge their bets” in the face of risk. Insurance, in its many forms,is the classic example of a hedge instrument. So too, is the futuresmarket for hedging the price of commodities. In fact, a futures marketcan exist for anything, functioning as a market where bets can be placedon the course of the price or index that defines that market. Hedging inany market—whether it be commodities, real estate, or anything with anykind of economic consequences—is essentially the same as buyinginsurance against price changes.

A number of financial management systems have been proposed in the past.Exemplary systems include U.S. Pat. Nos. 4,232,367, 4,633,397,4,742,457, 4,752,877, 4,766,539, 4,839,804, 4,876,648, 5,083,270,5,101,353, 5,136,501 and 5,206,803. Broadly speaking, the prior art hasproposed several methods to transfer the types of risks, which arecommon to many people. These include banks, insurers, equities andcommodities exchanges, the bond and swap markets, and mutual funds, eachof which developed from a recognition that numerous parties with similarrisk exposures needed effective methods of transfer and a means ofdetermining the value of risk transfer at any given time.

These structures operate on the basis of transferring risk to an entitywhich utilizes one of two primary forms of capital structure: a capitalleveraging system (banks and insurance companies) or a capital matchingsystem (the exchanges and markets).

Under the capital leveraging system, an insurer may accept any type oramount of risk, subject to internal underwriting guidelines andregulatory restrictions. This format provides a significant degree offlexibility in the pricing, terms, and limits of risks accepted. Theseinsurers operate on the premise that premiums cover claims. Theircapital is available to pay claims if losses exceed premiums andinvestment income. The aggregate of policy liabilities though, isgenerally much larger than their combined premium and capital. So, likea bank, which could not pay if all depositors asked for their money,insurance companies are not generally designed to pay if all policiesclaimed their limits.

Leveraging capital, i.e., a small amount of capital compared to the riskexposures assumed, translates a small underwriting profit on premiuminto a substantial return on capital. Conversely, a relatively smallloss over premium results in a significant loss to capital. This systemdoes not absolutely assure an insurer's ability to pay in that aninsurer's policy limits are generally much larger than its assets.Hence, an insurer must only accept risks common to many people, limitingits exposure to each single risk to a small percentage of its capital,and relying on geographic and risk type diversification, as well asreinsurance, to protect its shareholder's capital. This works well whenlosses are predictable. It is when insurers accept unique ordifficult-to-place risks that premium as well as capital may not besufficient to cover claims. Even Lloyd's of London (which operates in amanner similar to a collection of small insurance companies with theexception that should losses exceed available funds, its underwritingmembers, similar to shareholders, can be forced, in theory, to pay up tothe limit of their assets) has experienced such difficulties.

Under the prior art, insurance policies have provided security toinsureds based on and no greater than the general claims paying abilityrating (the ability to pay claims) of an insurer to perform itsobligations. Although reinsurance has sometimes been available,reinsurance policies likewise protect the insurer only to the extent ofthe reinsurance company's capacity to pay loss claims as they accrue.

In contrast, a capital matching system such as an exchange, accepts riskby matching buyers and sellers, i.e., parties transfer risk to thoseaccepting it, in effect matching risk to capital. Under this systemparties transfer or accept risks which are easily quantified incomparatively small units, such as through futures and optionscontracts. It limits the types and conditions under which parties maytransfer to specifically defined contractual units, priced by themarketplace, being a price agreed between those parties wishing totransfer risk and those willing to accept it.

These narrowly defined contracts offer little flexibility in the riskbeing accepted. Although each investor can select the type and amount ofrisk accepted, parties transferring risks are not concerned with theperformance of a specific party having accepted a corresponding amountof risk. The exchange stands as the intermediary between all parties,perfectly matched, with its only exposure being the credit performanceof any one participant. Like Lloyd's, these parties' assets can beattached to secure their performance.

Each system operates on the basis of accepting risks which are common tolarge numbers of people. As financial transactions and our world ingeneral grow more complex, certain types of risk exposures have becomeincreasingly difficult to transfer in today's markets. In the insurancemarkets, catastrophic events and judicial reinterpretation have caused acontraction in some types of insurance capacity. It appears that today'sinsurance markets are frequently unable or unwilling to facilitate thetransfer of unique risks such as those with a high possibility of loss,where the loss could come earlier rather than later or with moreseverity than projected. The exchanges have taken some steps towardaddressing unique risks, such as catastrophe futures contracts, butagain the terms are restrictive and do not easily integrate with theflexibility of a reinsurance contract. In essence, neither the exchangesnor mutual funds can accept a single unique risk.

In spite of insurance companies and exchanges, the fact remains thatthere are no existing instruments that people can use to hedge most ofthe common, everyday risks they face. For example, workers have nodirect way to hedge against the pain of prolonged work stoppage.Retailers have no way to hedge against macroeconomic surprises in theglobal economy which could impact the availability of inventory items.And individuals have no way to hedge against government decisions—suchas war, economic embargoes, legislation and a myriad of otherpossibilities—that could substantially impact their livelihoods.

One limited attempt to address the above shortcomings has been presentedby the Iowa Electronic Markets (IEM), which are operated by faculty atthe University of Iowa Tippie College of Business as part of a researchand teaching mission. The IEM are real-money futures markets in whichcontract payoffs depend on economic and political events such aselections. More specifically, the IEM is a real-money, small-scalefutures exchange in which the ultimate values of the contracts tradedare determined by political events, financial events and economicindicators or other real-world events such as companies' earnings pershare (EPS) or stock price returns. Participants in these markets investtheir own funds, buy and sell listed contracts, and bear the risk oflosing money as well as earning profits.

The exclusive purposes of the IEM are teaching and research. Through theIEM as a teaching device, participants learn first-hand about theoperation of a financial market. Because they have an added incentive todo so, they often become better informed about events determining theultimate value of the contract being traded—be that a political race,the earnings per share of a company, the stock return of a company, orthe exchange rate between a foreign currency and the dollar. Through theIEM as a research venture, the markets provide insights into market andtrader behavior. Participation in the IEM is open to students, faculty,and staff at colleges and universities worldwide; IEM political marketsare also open to non-academic participants.

The IEM is operated as a not-for-profit venture. No commissions ortransactions fees are charged, and the method of issuing contracts andmaking final payoffs on these contracts ensures that the IEM does notrealize financial profits or suffer losses from market transactions.Although the IEM is under the regulatory purview of the CommodityFutures Trading Commission (CFTC), it is not regulated by, nor are itsoperator registered with, the CFTC or any other regulatory authority.

As noted above, the market operates on computer systems at the Henry B.Tippie College of Business of the University of Iowa; traders gainaccess through the World Wide Web. At the time of this writing, the homepage for the IEM is maintained by the University of Iowa.

While the IEM goes somewhat beyond traditional commodity futures in thetypes of contracts which are offered, much of the system is modeled onconventional futures trading principles. Accordingly, IEM, like othertraditional risk hedging methods such as insurance, offers a limitedvariety of contracts and provides incomplete markets and thus restrictsopportunities for risk management.

Thus, presently available risk hedging methods, including IEM, fail toaddress potential needs of parties including such problem as:

-   -   Inadequate contract diversity to address the vast range of        uncertainties for which risk hedging is potentially        advantageous;    -   Excessive transaction costs rendering small markets of limited        traders impractical;    -   Liquidity restrictions to trading viability in brick and mortar        futures markets;    -   Inadequate real time communications capabilities necessary for        market trading when traders are geographically dispersed;    -   Problems due to the absence of liquid secondary markets in        tickets, coupons, hotel and airline reservations, and advance        purchase orders; and    -   Problems in inventory management

Thus, there continues to be a long felt need for a system and a platformwhich brings buyers and sellers together, and thus engenders a viableand populated market across which a nearly unlimited variety of hedgeinstruments can be created and executed. But, because of a variety ofheretofore insurmountable barriers, no such platform has yet emerged inthe world.

SUMMARY OF THE INVENTION

In spite of existing brick and mortar futures markets, there exists acontinuing need for additional futures markets to facilitate the vastvariety of risk management needs. As described in the Prior Art section,liquidity is the lifeblood of existing futures markets. Traditionalfutures markets such as the CME require a minimum trading volume beforethey are able to sanction and administer the trading of a security.Without a rather high minimum trading volume, the market cannot breakeven.

Accordingly, in view of the shortcomings of prior art, it is an objectof the present invention to provide a risk hedging, contract tradingsystem whereby prospective traders can transact with each other with lowtransaction overhead, in real-time, near instantaneous speed,twenty-four hours-per-day, 7 days-per-week, and without any intermediaryor broker.

It is also an object of the present invention to enable and providemarkets, for trading to any interested parties, risk hedging contractspertaining to a virtually unlimited range of possible events.

It is also an object of the present invention to enable and provide asystem for creating and managing markets for risk hedging contractshaving de minimus transaction costs so that a minimum market size ortrading volume is not necessary for efficiency, practicality orviability.

It is a further object of the present invention to act as an umbrellaaggregator, facilitator, administrator and electronic platform forsupporting a nearly unlimited number of simultaneous trading markets inhedge instruments, and to act as a disseminator of informationpertaining to the activities on these markets.

It is still a further object of the present invention to enable andprovide a trading platform that is equally and nearly instantaneouslyaccessible to traders who may be located anywhere in the world.

It is still a further object of the present invention to aggregate inone electronic platform support for simultaneous, but separate, tradingof publicly-traded hedging instruments and trading of restricted hedginginstruments, the trading of which is restricted to a group of speciallyauthorized traders.

It is a still further object of the present invention to provide atrading platform together with all necessary support and brokerageservices, including user-friendly Web interface, newswire, settlement,clearance, money transfer, and accounting management features.

It is a still further object of the present invention to act as agovernment sanctioned institution to interact with government regulatoryagencies so that all activities within the platform comply withgovernment regulations and principles of fairness, integrity, and publictransparency.

It is a still further object of the present invention to be easilyexpandable and adaptive to incorporate the trading of new hedginginstruments and, also, interact with new telecommunications media.

These and other objectives and advantages of the present invention areprovided by a computer-network based futures trading system, orplatform, which is electronically accessible by prospective traders, forenabling transactions related to futures contracts and futures contractbundles.

The computer-network based platform is preferably implemented as aninternet-accessible web site, having an interactive interface and beingconfigured to enable anyone who accesses the platform to apply for a newaccount and to view data and news related to activity within marketswithin the platform. The interface is configured to enable registeredusers to log in, place trades, and perform related maintenanceactivities related to their account.

The computer-network based system enables transactions relating tobundles of futures contracts, where each bundle includes at least twofutures contracts, each of which corresponds to one of at least twofuture possible outcomes of a phenomenon at a time of maturity of thecontracts. The futures contract bundles are defined to pay an aggregatefixed sum at maturity and each of constituent futures contracts pay thefixed sum at maturity upon the happening of the future possible outcomeof the phenomenon associated with that particular risk managementcontract. Conversely, each of the risk management contracts pay a zerosum at maturity upon the non-happening of the future possible outcome ofthe phenomenon associated with that specific risk management contract.

Transactions on contract bundles include purchase and sale of completebundles from the market authority, which always stands ready to sell orpurchase bundles at a fixed, prestated price.

The computer-network based system also enables transactions relating toindividual futures contracts, each of which are traded in an individualmarket. Owners of contracts may place limit orders to sell one or morecontracts. Likewise, potential buyers of contract(s) may place limitorders offering to purchase one or more contracts at a certain price.

The computer-network based system also enables transactions relating tosets of individual futures contracts which do not form a completebundle. In particular, at any given time the market authority hasdiscretion either to split one contract into several separately tradedcontracts, or to recombine several contracts into one contract. Thecomputer-network based system will facilitate splitting andrecombination in an efficient way that is substantially automated andthat does not reduce the event-based liquidation value of any contractowner.

The computer-network based system also has a means for soliciting,evaluating, and optionally implementing ideas for innovative newcontracts and contract bundles the trading of which enables hedging innew dimensions.

The computer-network based system also acts an umbrella aggregator,facilitator, and administrator of potentially thousands or millions ofsmall, simultaneous markets, each of which may have virtually zerotrading volume individually. This is possible because the platformprofits from aggregate activity integrated over all of the smallindividual markets. Thus, the platform is able to (i) effectively“complete” the securities market for risk management; (ii) act as anumbrella portal where hedgers can go to access millions of futuresmarkets in one place; and (iii) provide a direct channel to the hedgingand speculating clientele for advertisers and others.

The objectives and advantages of the present invention are also providedby a method for managing risk which, although preferably implemented ina computer-network based system, may also be implemented in anon-computerized method or process. Furthermore, certain aspects of theinvention are achieved by the sale and trading among persons of what maybe termed “contracts.” Accordingly, certain methods or processes withinthe scope of the present invention may be conveniently defined, in part,by the definition of certain types of contracts to be traded.

Thus, in the following examples where specific types of “contracts” aredescribed, it should be understood that certain embodiments of thepresent invention may relate to the specific or general methods forforming such contracts, methods for making an initial public offeringsfor such contracts, methods for creating a secondary market for tradingin such contracts and methods relating to the redemption or settlementof such contracts, or combinations of the foregoing. Each such method,while potentially having high level similarities between and amongdifferent contract types, may also have unique and specific method stepswhich are related to or derive from the specific contract types and thedetails of the contract type.

Accordingly, for the purposes of this disclosure, one of skill in therelevant field of art will understand that each description of a “typeof contract” may be regarded, in part, as a shorthand for a novel anddifferent method of forming such contracts, methods for making aninitial public offerings for such contracts, methods for creating asecondary market for trading in such contracts and methods relating tothe redemption or settlement of such contracts, or combinations of theforegoing, where the specific method steps derive from the attributes ofeach specific type of contract. In other words, one of skill in therelevant field of art will understand that each description of a “typeof contract” is not merely a description of the terms and conditions ofa legal agreement.

One aspect of the present invention is that, because of new software anddatabase technologies and the instantaneous multimedia, multi-usertelecommunications capability offered by the World Wide Web, it is nowprofitable to facilitate and administer the trading of futures contractswith very low or even negligible trading volume. This is because given“template” software and Web interfaces for futures markets, it isvirtually costless to electronically reproduce this template again andagain to facilitate the trading of highly specialized hedginginstruments—even instruments with extremely low popularity and tradinginterest. If at least two counterparties (one buyer and one seller) areinterested in trading a futures contract, everyone is better off if amarket is created to enable the two parties to establish theirpositions: the two counterparties benefit from establishing theirpositions, and any third party speculators and spectators benefit fromeither participating or just passively observing the transaction price.(I.e., the transaction price reveals information about the traders'expectations.)

BRIEF DESCRIPTION OF THE DRAWINGS

A more complete understanding of the present invention and itsadvantages will be readily apparent from the following DetailedDescription taken in conjunction with the accompanying drawings.Throughout the accompanying drawings, like parts are designated by likereference numbers.

FIG. 1 illustrates a preferred embodiment of the present inventionimplemented as a general internet-based webserver.

FIG. 2 shows an expanded view of the Market Authority 500.

FIG. 3 shows an expanded view of the Clearance and Settlement 690function.

FIG. 4 shows a general top level web-site design in accordance with apreferred embodiment of the present invention.

FIG. 5 shows an expanded view of the pages which are located below theNew User Registration Page 450.

FIG. 6 shows an expanded view of some of the pages which belong to thePublic Pages 470.

FIG. 7 shows a flow chart of a member interacting with the Trade Engine300 function of FIG. 1.

DETAILED DESCRIPTION OF THE INVENTION

I. Types of Contracts

As noted in the summary of the invention, an objective of the presentinvention is to enable and provide a new form of risk hedging. While thepresent invention is directed to a novel method and apparatus for riskhedging, proper understanding of the invention first requires anunderstanding of various hedging contracts or instruments, the sale andtransactions in which are a necessary adjunct to the inventive processand apparatus. Accordingly, next will be discussed several types ofcontracts or hedging instruments which can be used in the inventivesystem. For convenience, these types of contracts are referred to hereinas Type I contracts, Type II contracts and Type III contracts, and/orFixed Pay-out hedging instruments, Variable pay-out hedging instruments,and Hedglet bundles. Based on the present disclosure, however, one ofordinary skill in the art will appreciate that the present invention isnot limited to these types of contracts and many other types ofcontracts could be employed to hedge risk without departing from thespirit of the present invention.

A. Type I (“Event”) Contracts

As the name suggests, event contracts pay out based on the realizedoutcome of contingent events. By way of example and not by way oflimitation, an event contract may pay off either $10 or $0 depending onthe outcome of a specified event. If a particular criteria is met (i.e.a particular outcome occurs), then the claim pays off $10. Otherwise,the contract pays off $0. Event contracts are cash settled. Eventcontracts can be designed around almost any risky event in the world.For instance, events may be a state's gubernatorial election; firm'squarterly earnings announcement; or Federal Reserve Open MarketCommittee (FOMC) meeting announcements. Examples of outcomescorresponding to these events might be, respectively, whether theincumbent governor wins re-election; whether the firm meets or beatsanalysts' expectations; or whether the Fed hikes interest rates. Thereare an unlimited number of possible events which can be commodified withevent contracts and therefore render, for the very first time, theirassociated risks hedgeable.

Type I contracts will be designed specifically to hedge economic riskscontingent on future events. Contracts are designed in such a way thatthey can be used, with reasonable predictability, by participants in thecontract market to neutralize, or at least reduce, the risk of anadverse outcome with respect to the underlying event. Like futurescontracts traded in existing contract markets, they are intended asrisk-shifting vehicles.

A full understanding of the types of contracts and the present inventionrequires an appreciation of the following terminology which is usedthroughout this application:

The “market authority” is the official agent charged with the absoluteauthority and ability—subject to legal limitations—to issue, expire,terminate, buy, sell, or otherwise alter the nature of the instrumentstrading in the market, and to alter the nature of the market itself.

A state of nature “s” is a possible final outcome realized at aprespecified date T. States of nature, s and s′, are mutually exclusiveif they cannot occur together. A set of states, S={s1, s2, . . . , sN}is complete if: (i) the members of S are all mutually exclusive, and(ii) every possible final outcome is a member of S. The number, N, ofstates of S can be, in principle, any number greater than or equal to 2.

A contract is a tradable instrument that pays off a nonzero value in onestate of nature, s, and $0 in all other states of nature at date T. Inthe following examples and throughout this specification, forsimplicity, the nonzero payoff value of the tradeable instrument in theone state of nature will be $10, however, one of ordinary skill in therelevant art will appreciate that any value can be used.

In the following examples, date T will sometimes be referred to as the“expiry” date, and will typically include a time.

A “contract bundle” is a collection of contracts whose aggregate payoffat date T in any state of nature is $10. For instance, suppose S={s1,s2, s3, s4, s5} is a complete set of possible states for a given event.Then a bundle might consist of the set {A, B, C, D, E} of 5 contracts.In this example:

-   -   At time T, contract #1 (A) pays off $10 if state s1 occurs, and        $0 otherwise.    -   At time T, contract #2 (B) pays off $10 if state s2 occurs, and        $0 otherwise.    -   At time T, contract #3 (C) pays off $10 if state s3 occurs, and        $0 otherwise.    -   At time T, contract #4 (D) pays off $10 if state s4 occurs, and        $0 otherwise.    -   At time T, contract #5 (E) pays off $10 if state s5 occurs, and        $0 otherwise.

Because the possible states for a given event {s1, s2, s3, s4, s5} aremutually exclusive, and because the set S includes all possibleoutcomes, one (but only one) of the states will be achieved at time T.Thus, regardless of which one of the states is achieved at time T, theaggregate value of the contract bundle will always be $10.

According to the present invention, there can be otherwise identicalcontracts and/or contract bundles whose only difference is theexpiration date T. For example, quarterly earnings announcements occurfour times a year. Thus, at any one time, there can be a first set ofcontracts which pay off depending on the outcome of Company A's firstquarter announcement; a second set of contracts whose payoff depends onCompany A's second quarter results; and a third and fourth set which payoff depending on Company A's third and fourth quarter results,respectively. The collection of all these contracts would be referred toas the “earnings announcement class for Company A.” All contracts inthis class with the same expiration date would be referred to as thedate T contract series of that class. For instance, “the second quarterseries contract of Company A” refers to the contracts whose payoff isdetermined by the outcome of Company A's earnings announcement in thesecond quarter. Note that Company A's earnings announcement class couldconsist of more or less than four contract series depending on how manyexpiration dates the market authority sanctions contracts for.

TYPE I CONTRACT EXAMPLES

To further explain and clarify the concept of a Type I, or event,contract several exemplary and illustrative examples are provided below.

Example 1 Gubernatorial Election

State A is scheduled to hold a gubernatorial election in November. InFebruary of the same year, the market authority could issue bundles ofcontracts which pay off depending on the outcomes of the election, ascertified by the State's Secretary of State.

For the gubernatorial race, the set S={incumbent wins, otherwise}constitute a complete set of states at T of the results of thegubernatorial race. Accordingly, the bundle would consist of the set {A,B} of N=2 contracts. The bundle would sell for $10 where:

-   -   Contract A pays off $10 if, and only if, the incumbent governor        wins reelection.    -   Contract B pays off $10 if, and only if, anybody else is        certified as the winner of the gubernatorial race, for any        reason.

The expiry date T is the day the Secretary of State (or the appropriateelection authority) certifies the winner of the gubernatorial race inthat state. If the ultimate realization of this date is in controversy,the decision of the market authority is final.

Example 2 Binary Contract

The gubernatorial race example is special kind of Type I contractreferred to herein as a binary contract or hedglet. A Binary Hedglet isone wherein there are two possible outcomes: either an event occurs ordoes not occur. For example, the set S={event occurs, event does notoccur} constitute a complete set of states at T of the results of someevent. Accordingly, the bundle would consist of the set {Yes, No} of N=2contracts. The bundle would sell for $10 where:

the Yes contract pays off $10 if, and only if, the event occurs;

The No contract pays off $10 if, and only if, the event does not occur,for any reason.

Thus, exactly one contract of the contract-pair pays out $10 at expiry;the other pays $0.

As an example, consider a binary hedging bundle based on the 1^(st) Qearnings of Zoran, Inc. An earnings announcement hedge bundle for 1stQtr earnings of Zoran, Inc. may be listed by a Market Authority thatpays out $10 if reported earnings are equal to or greater than theirprojected value, e.g., $0.02 (rounded to the nearest penny) per share(and $0 if they are not). The contracts making up the hedglet bundlewould specify other details such as, for example, whether payout isbased on the earnings before special items.

The Yes hedging instrument pays out $10 if earnings are equal or greaterthan $0.02 per share (and $0 if they are not). As the perception ofearnings changes over time, active trading prices for the Yes and Nohedging instruments would fluctuate as hedgers and speculators buy andsell earnings hedging instruments over a Market Authority.

Example 3 AOL Earnings Announcements

The “big board” NASDAQ and NYSE traded companies announce quarterlyearnings 4 times per year on a regular (usually pre-announced) schedule.Although an earnings announcement does not become official until thecompany files a Form 10-K or 10-Q with the SEC, a hedging contract candefine the contracted event as desired. For example, the contractedevent could be defined as the earnings before special items as listed ina Form 10-K, 10-Q, or other official filing. Alternatively, thecontracted event may be the earnings is an official company pressrelease, or as reported in the Wall Street Journal, or any other reportor announcement as specified in the hedging instruments.

The states which define the possible outcomes in this situation pertainto whether AOL “beats,” “meets,” or “misses” a benchmark (or “expected”)earnings number. Thus, based on the above, the set S={beats, meets,misses} constitute the complete set of possible states at T for AOLEarnings. Accordingly, the bundle would consist of the set {A, B, C} ofN=3 contracts. The bundle would sell for $10, where the expectedearnings number is $0.40 and:

-   -   Contract A pays off $10 if and only if AOL's 1st Qtr earnings        (before special items) exceeds $0.41 (rounded to the nearest        penny) per share.    -   Contract B pays off $10 if and only if AOL's 1st Qtr earnings        (before special items) falls within the range $0.39-$0.41        (rounded to the nearest penny) per share.    -   Contract C pays off $10 if and only if AOL's 1st Qtr earnings        (before special items) falls below $0.39 (rounded to the nearest        penny) per share.

Contract B's payoff range “$0.39-$0.41” intends to proxy for a bestestimate of AOL “meeting” earnings expectations. The Market Authorityacting in accordance with the present invention determines/chooses thisnumerical range based on its own private judgment. To pick these payoffcriteria, the Market Authority can consult First Call or other financialanalyst forecast databases (including “whisper number” databases). Nomatter, the Market Authority preferably reserves the right to pick thisnumber internally any way it chooses. Even more preferably, the MarketAuthority does not publicly commit to any predetermined formula forchoosing the payoff criteria; it may not even disclose how it choosesthem.

Likewise, contracts A and C pay off $10 if AOL, respectively, “beats”and “fails to meet” earnings expectations.

For contract purposes, the Market Authority, acting in accordance withthe present invention, can define the “official” earnings number asappropriate to the needs of the hedging market. For example, theofficial earnings numbers may be defined as “earnings before specialitems” listed in the document (Form 10-K or 10-Q) officially filed withthe Securities and Exchange Commission. This document is publiclyavailable for download on FreeEdgar.com, or through sec.gov, ostensiblywithin 24 hours of filing. Therefore, the settlement date is on the dayafter Form 10-K or 10-Q is first available on FreeEdgar.com. This dateis not specified as a calendar date because it depends on when AOLofficially files with the SEC. However, because companies may announcetheir earnings before the 10-K or 10-Q is published, a Market Authoritymay instead define the official earnings number as whatever numbers thecompany provides in such an announcement.

For the purposes of this example, the expiry date T is the day afterForm 10-K or 10-Q is first available through a specified source such asthe web site FreeEdgar.com or sec.gov. Note that the expiry date T neednot be specified as a calendar date because it depends on another event,e.g., when AOL officially files with the SEC. Sometimes a company maypre-announce earnings. However, the settlement date in the presentexample is based on the official SEC 10-K or 10-Q filing, not thepre-announcement or any version of company press release. Moreover, if acompany later amends and re-compute earnings, the preferred embodimentof the present invention does not use the re-computed number. Thus, thepayoff is preferably based on the original SEC filing.

The AOL Earnings Class: At any given time, many different earningscontract series for AOL can be trading, corresponding to the futurequarterly earnings announcements. At the discrescion of the MarketAuthority, the series may be limited to the next four earnings report,corresponding to the reports expected over the next twelve months. Then,after one series expires, the year-ahead one for the same quarter isintroduced to start trading. For instance, typically AOL would beexpected to file its 4th quarter 1999 earnings with the SEC near the endof January, 2000. Immediately afterwards the Market Authority couldissue a series based on 4th quarter, 2000 earnings for trading.

Earnings Series Trading Start Expiry 4^(th) Qtr. 2000 Jan. 31, 2000 atSEC filing 1^(st) Qtr. 2000 Mar. 31, 2000 at SEC filing 2^(nd) Qtr. 2000Jun. 30, 2000 at SEC filing 3^(rd) Qtr. 2000 Sep. 30, 2000 at SEC filing

However, the Market Authority is not limited to issueing a series ofcontract that cover approximately a twelve month time-span. Rather, atits discretion, the Market Authority may issue any series for whichthere is significant demand. For example, the Market Authority may issuecontract series for AOL earnings over the next eight or more quarters ifthere is sufficient market demand for such hedging instruments.

Example 4 FOMC Interest Rate Changes

The Federal Open Market Committee (FOMC) meets eight times per year. Oneof the outcomes of the meetings is the setting or adjustment of theprime interest rate. For a contract bundle, or contract bundle seriesdirected to the Federal interest rates (Fed Interest Rates), a bundlecan consist of the set {A,B,C,D,E} of 5 contracts, in which:

-   -   Contract A pays off $10 if and only if the interest rate is        lowered by more than 25 basis points between midnight EDT June        29, and midnight EDT Aug. 23, 2000.    -   Contract B pays off $10 if and only if the interest rate is        lowered by exactly 25 basis points between June 29 and August        23.    -   Contract C pays off $10 if and only if the interest rate is        unchanged between June 29 and August 23.    -   Contract D pays off $10 if and only if the interest rate is        raised by exactly 25 basis points between June 29 and August 23.    -   Contract E pays off $10 if and only if the interest rate is        raised by more than 25 basis points between June 29 and August        23.

Based on this example, at any given time, eight Fed Interest Rate seriesmight be trading. These eight series correspond roughly to the eightscheduled FOMC meeting per year. After one series expires, thecorresponding year-ahead one is introduced to start trading. Forinstance, as indicated in the schedule below, on Feb. 16, 2000 theseries based on how much the Fed changes interest rates between Jan. 1,2001 and Feb. 15, 2001 starts trading. This series trades continuouslyfor one year until Feb. 15, 2001, the expiry date. Note that while the“rate accrual period” intends to roughly approximate the period between2 FOMC meetings, the outcome is not based on whether the FOMC meets onthose dates or not. The outcome is based on the accumulated net amountthe Fed changes interests rates during the period between midnight EDTJan. 1, 2001 and midnight EDT Feb. 16, 2001.

In this example, only eight series of contracts based on the FOMCinterest rate changes are trading. However, one skilled in the art willrecognize that the invention is not so limited, and that a MarketAuthority may issue as many series of contracts may as needed or desiredbased on market conditions and demand.

Rate Accrual Period Trading Start Expiry Jan. 1, 2001-Feb. 15, 2001 Feb.16, 2000 Feb. 15, 2001 Feb. 16, 2001-Mar. 31, 2001 Apr. 1, 2001 Mar. 31,2001 Apr. 1, 2001-May 22, 2001 May 23, 2001 May 22, 2001 May 23,2001-Jun. 28, 2001 Jun. 29, 2001 Jun. 28, 2001 Jun. 29, 2001-Aug. 22,2001 Aug. 23, 2001 Aug. 22, 2001 Aug. 23, 2001-Oct. 15, 2001 Oct. 16,2001 Oct. 15, 2001 Oct. 16, 2001-Nov. 22, 2001 Nov. 22, 2001 Nov. 22,2001 Nov. 22, 2001 v Dec. 31, 2001 Jan. 01, 2002 Dec. 31, 2001

Transactions of Type I Contracts

A full understanding of the types of transactions in the variouscontracts in the present invention requires an appreciation of thefollowing terminology and concepts pertaining to market transactionsinvolving contracts:

A “trader” is any person authorized to buy or sell, or to make offers tobuy or sell, contracts or contract bundles in the market.

“Sale Of A Bundle By The Market Authority”—When the market authorityauthorizes a new series of contracts for trading, it stands ready tosell to traders, at any time, contract bundles pertaining to that seriesof contracts for a fixed price. Ignoring transactions fees, this fixedprice is typically equal to the aggregate payoff of a complete bundle ofcontracts at expiry. By way of example, in the following discussions thefixed price is $10, however, any other value can also be used.

“Passive Redemption Of Bundles By The Market Authority”—The marketauthority stands ready to redeem for $10 any complete bundle ofcontracts offered for sale to it by any traders.

“Active Redemption Of Bundles By The Market Authority”—The marketauthority may, at its discretion, actively monitor the order queues andpurchase every complete bundle that it can construct and buy for under$10 (e.g. for $9.75). In making such purchases, the Market Authorityrespects the priority of other traders' orders in the queue, and itnever unfairly jumps ahead of other legitimate higher priority ordersqueued by traders.

“Splitting of a Contract”—The market authority may at any time elect tosplit any contract into two or more contracts. When a contract, forinstance contract A, is designated for splitting into M contracts, sayA.1-A.M, the following occurs:

-   -   (i) The market authority announces the split and defines the        payoffs of the M contracts subject to the following conditions:        -   If at date T, original contract A pays off $10 in state s,            and $0 otherwise, then the aggregate payoff of contracts            A.1-A.M at date T must also pay off $10 in state s and $0            otherwise. In this sense, owning contract A is equivalent to            owning: the set of M contracts A.1-A.M.        -   Each of the individual M contracts must pay off either $10            or $0 at date T.        -   These conditions are fulfilled if the market authority            partitions the state s into M mutually exclusive states {s1,            . . . ,sM} such that the union of s1, s2, . . . & sM equals            state s; and, then, the market authority defines contract            A.j as paying off $10 if, and only if, state sj occurs, and            $0 otherwise.    -   (ii) The market authority replaces every contract A held in each        trader's account with contracts A.1-A.M.    -   (iii) All contract bundles sold in the future by the market        authority contains the new contracts A.1-A.M in place of        contract A.

“Merger of Contracts” The market authority may at any time elect tomerge two or more contracts into a single contract. When M contracts,A.1-A.M, are designated for merger into one contract, A, the followingoccurs:

-   -   (i) The market authority announces the merger, and defines the        new contract A as follows. Suppose at date T the individual        contracts Aj pay off $10 in state sj and zero otherwise. Define        the aggregate state s as the union of states {s1, . . . ,sM}        (for j=1 to M). Then contract A pays off $10 if, and only if, at        date T state s is realized; otherwise A pays $0. In this sense,        owning contract A is equivalent to owning the M contract,        A.1-A.M.    -   (ii) The market authority replaces every set of contracts        A.1-A.M held in every trader's account with contract A. Note        that if a trader holds some, but not all, of the M contracts,        then his contracts will not be merged and will not be replaced        by contract A. Only complete sets of A.1-A.M will be replaced by        A.    -   (iii) All contract bundles sold in the future by the market        authority will contain contract A in place of contracts A.1-A.M.    -   (iv) The markets for the individual contracts Aj will continue        trading until every contract Aj has been redeemed by the market        authority. In the meantime, contract bundles containing original        contract A will still be redeemable for $10.

“Limit Order For Purchase/Sale Of A Contract”—Traders may place limitorders to buy or sell individual contracts. A limit order to purchase acontract A is an outstanding offer to buy at a certain price for acertain period of time. Analogaously, a limit order to sell a contract Ais an outstanding offer to sell at a certain price for a certain periodof time. Typically a limit offer must specify:

-   -   numbers of A contracts desired,    -   maximum/minimum price per A contract the aspiring buyer/seller        is offering, and    -   an expiration date after which the offer terminates.

Acceptance of an outstanding limit order is binding on the offeror. Theorder is automatically withdrawn at 12.01 A.M. on the expiration date.However, traders may cancel their limit order at any time prior to theirstated expiration date by placing a cancellation order.

“Market Order For Purchase Of A Contract”—Traders may also place limitmarket orders to buy or sell hedging contracts. A market order is anoffer to buy or sell a contract at the current market price for acertain period of time. The offer must typically specify:

-   -   numbers of A contracts desired, and    -   an expiration date after which the offer terminates.

“Block Order For Purchase Of A Contract”—Traders may also place blockorders. Typically, such orders are arranged outside of the market andare for the sale or purchase of large numbers of contracts. Although theblock order may be prearranged, the market is used to facilitate theactual block order transaction. are transacted through the market.

Acceptance of an outstanding limit order is binding on the offeror.However, traders may cancel their limit order at any time prior to theirstated expiration date by placing a cancellation order.

Description of Type I Contract Markets

Consider a given series of contracts. Suppose this series of contractsconsists of bundles of N contracts each. Then at any given time, therewill be N distinct parallel markets—one market for each of the Ncontracts.

At any given instant before expiry, any one of these N markets willconsist of the following:

-   -   a market authority who stands ready to sell and redeem a bundle        of N contracts for a predetermined price, for example $10 per        bundle,    -   a collection of traders' accounts qualified to transact in this        market; that is, a collection of accounts qualified to place        limit and buy orders on these contracts,    -   a queue of limit orders to buy contracts. The queue can be        arranged in priority according to any one of (or more than one)        the following criteria in order of importance:        -   (i) price per contract (highest order first)        -   (ii) number of contracts offered (greatest quantity first)        -   (iii) time order was entered (earliest order first)    -   a queue of limit orders to sell contracts. The queue can be        arranged in priority according to any one of (or more than one        of) the following criteria in order of importance:        -   (iv) price per contract (lowest price first)        -   (v) number of contracts offered (greatest quantity first)        -   (vi) time order was entered (earliest order first), and    -   a mechanism for communicating to all traders' accounts timely        information about the status of the market, including the price        and volume information of recent trades, and the best limit        prices and quantities in the limit buy and sell queues.

Use of Type I Contracts

Suppose there are N states of nature {s1, s2, . . . , sN} which comprisea complete set of possible outcomes of an event. This means the ultimateoutcome of the event must be either s1, s2, . . . , or sN. Consider apotential hedger-who can be anyone from a large corporation to a privateindividual—who finds herself in a risky position that pays off Q(sn)dollars in state sn. Q(sn) may be negative or positive. Without loss ofgenerality, suppose these payoffs are arranged in order of size so thatQ(s1)>Q(sn) for all n>1.

Without hedging, this potential hedger cannot guarantee herself of acertain outcome, and she would be at the mercy of whatever outcome snand payoff Q(sn) that befalls her.

But suppose there is a bundle of futures contracts #1, #2, . . . , #Nwhich are available. These contracts respectively pay $10 if and only ifstate s1, s2, . . . , sN occurs. To completely hedge her position andguarantee herself a riskless position, this hedger should buy:

-   -   (a) {Q(s1)−Q(s2)}/10 shares of contract #2.    -   (b) {Q(s1)−Q(s3)}/10 shares of contract #3    -   (z) {Q(s1)−Q(sN)}/10 shares of contract #N.

This position assures the hedger a completely riskless net profit (afterpaying for the contracts) of:p=p(s1)Q(s1)+p(s2)Q(s2)+ . . . +p(sN)Q(sN)  (Eq 1)

This use of Type I contracts will be more fully understood afterconsidering the following examples:

Hedging Method Example 1 Earnings Announcements

As described above, an earnings announcement contract pays off based onwhether a company's quarterly announcement “beats,” “meets,” or “misses”a benchmark (or “expected”) earnings number. For any particular earningsannouncement, the Market Authority would offer, for $10, a bundleconsisting of a set {A,B,C} of 3 contracts which pay $10 if and only ifAOL's earnings exceed, meet, or fall below the expected earnings.

Suppose an investor, Pete, holds a $100,000 long position in AOL stock.While Pete is optimistic about AOL long term, Pete is concerned aboutshort term volatility in the AOL stock price. (Perhaps Pete manages ahedge fund, and short term volatility would scare away his clients; orperhaps Pete is highly margined, and price volatility might make Peteliable to a margin call.) In any case, AOL is due for an earningsannouncement, and Pete is worried that if AOL does not beatexpectations, AOL stock will fall. In particular, Pete believes hisunhedged AOL portfolio would be worth one of the following:

-   -   (a) $125,000 if 1st Qtr earnings exceeds $0.41 cents;    -   (b) $95,000 if 1st Qtr earnings falls within $0.39-$0.41 range;    -   (c) $85,000 if 1st Qtr earnings misses the $0.39 expectations        threshold.

Thus, to fully hedge his position, Pete, using Eq. 1, would buy thefollowing contracts:

-   -   (i) 3000 type B contracts=(125,000−95,000)/10; and    -   (ii) 4000 type C contracts=(125,000−85,000)/10.

Then regardless of whether AOL beats, meets, or fails to meet earningsexpectations, the value of Pete's hedged portfolio is locked in at$100,000 after the earnings announcement.

To put some numbers on the consequences of Pete's hedging position,suppose, for instance, the market believes AOL has a 25% chance ofbeating expectations, a 50% chance of meeting expectations, and a 25%chance of falling short of expectations. Then Pete would pay $15,000(=3000×$10×0.50) for 3000 type B contracts, and $10,000 (=4000×$10×0.25)for 4000 type C contracts—for a total upfront payment of $25,000.

While the expected value of the Pete's portfolio is $100,000, withouthedging the realized value after the earnings announcement could beanywhere from a high of $125,000 to a low of $85,000. So Pete's unhedgedportfolio is potentially volatile.

However, with hedging, after the earnings announcement, Pete's portfolionet the $25,000 upfront payment would be:

Initial Value Upfront Change Payoff Of Net Final Value Of Pete's PaymentFor B In Contract Of Pete's Portfolio & C Contracts Value PortfolioPortfolio 100,000 −25,000 +25,000 0 100,000 100,000 −25,000 −5,000+30,000 100,000 100,000 −25,000 −15,000 +40,000 100,000

The first row of numbers show Pete's situation if AOL beats earnings. Inthis event, Pete's B & C contracts are worthless, but Pete recovers hisoriginal $25,000 investment for the B & C contracts because the value ofhis AOL stock increases by $25,000. The second and third rows of numbersshow Pete's outcome if AOL does not beat expectations. If AOL meets orfails to meet earnings expectations, Pete recovers his initialinvestment in the contracts plus the drop in value of his portfolio,because the B & C contracts pay off in the exact compensating amounts.

Therefore, once hedged, Pete is guaranteed a riskless outcome of$100,000 after netting out the original upfront investment.

What happens if the Market Authority made a mistake and issued contractsbased on wrong earnings expectations?

Suppose the market expects, as in the preceding setting, AOL to reportearnings in the $0.39-$0.41 range. However, the Market Authorityover-estimates market expectations for AOL's earnings, and issues for$10 the following bundle {D,E,F} of 3 contracts instead of {A,B,C}:

-   -   Contract D pays off $10 if and only if AOL's 1st Qtr earnings        (before special items) exceeds $0.61 (rounded to the nearest        penny) per share.    -   Contract E pays off $10 if and only if AOL's 1st Qtr earnings        (before special items) falls within the range $0.59-$0.61        (rounded to the nearest penny) per share.    -   Contract F pays off $10 if and only if AOL's 1st Qtr earnings        (before special items) falls below $0.59 (rounded to the nearest        penny) per share.

First, the market would pay virtually nothing for contracts D and E, andalmost $10 for contract F.

Can Pete still hedge his portfolio with {D,E,F}? Unfortunately, not.Contracts D and E are useless to Pete, because all the volatility inPete's portfolio occurs in the earnings range of $0.39-$0.41. Contracts{D,E,F} cannot distinguish between whether AOL meets $0.39-$0.41 or not.So these contracts do not enable Pete to hedge his risk.

However, the existence of contracts {D,E,F} do not make Pete worse off.After all, Pete can always choose not to participate. There is no reasonfor Pete to buy {D,E,F} so Pete would probably just not take positionson these contracts. Pete is not made worse off by the mere existence ofthese contracts, since he can always ignore them.

Another Application of the AOL Earnings Contracts

In the previous example the hedger, Pete, was an AOL investor. We do notwant to leave the impression that only financial market investors coulduse AOL earnings to hedge risks. Indeed, anybody with AOL-relatedbusiness risk, including AOL's creditors, employees, suppliers,customers and even competitors, will find AOL earnings contracts usefulfor hedging.

Consider a small company, Sysco. Suppose Sysco is a supplier ofoperating hardware to AOL's network headquarters in Virginia. In fact,AOL is Sysco's single largest customer. When AOL's business booms, AOLwill order more hardware from Sysco. In slower times, AOL will reduceits orders. In either case, Sysco believes AOL's quarterly earningsannouncements reflect how well AOL is doing and, accordingly, how muchAOL will expand or reduce needs for Sysco's products. In particular,Sysco believes the net present value (NPV) of its AOL business, ifunhedged, would change by:

-   -   (a) $1,250,000 if AOL 1st Qtr earnings exceeds $0.41 cents;    -   (b) $950,000 if AOL 1st Qtr earnings falls within $0.39-$0.41        range;    -   (c) $850,000 if AOL 1st Qtr earnings misses the $0.39        expectations threshold.

To fully hedge its business risk, Sysco would buy from the MarketAuthority:

-   -   (i) 30,000 type B contracts=(1250 K−950 K)/10; and    -   (ii) 40,000 type C contracts=(1250 K−850 K)/10.

To put some numbers on the consequences of Sysco's hedging position,suppose, for instance, the market believes AOL has a 25% chance ofbeating expectations, a 50% chance of meeting expectations, and a 25%chance of falling short of expectations. Then Sysco would pay $150,000(=30000×$10×0.50) for 30000 type B contracts, and $100,000(=40000×$10×0.25) for 40000 type C contracts—for a total upfront paymentof $250,000.

The expected value of the Sysco's AOL business is $1,000,000. But afterthe earnings announcement the realized value could be anywhere from ahigh of $1,250,000 to a low of $850,000. So Sysco's unhedged businessrisk is potentially volatile.

With hedging, after the earnings announcement, Sysco's portfolio net the$250,000 upfront payment would be:

Initial Value Upfront Change Payoff Of Net Final Value Of Sysco'sPayment For B In Contract Of Sysco's Portfolio & C Contracts ValuePortfolio Portfolio 1,000,000 −250,000 +250,000 0 1,000,000 1,000,000−250,000 −50,000 +300,000 1,000,000 1,000,000 −250,000 −150,000 +400,0001,000,000

Hence, no matter if AOL beats, meets, or fails to meet earningsexpectations, the value of Sysco's hedged portfolio is locked in at$1,000,000 after the earnings announcement. As Sysco, all of AOL'sindividual suppliers, programmers, employees, and third-party contractsmay use AOL earnings announcements to hedge their AOL-related businessrisk.

Hedging Method Example 2 FOMC Interest Rate Changes

As discussed above, an FOMC contract bundle could consist of a set{A,B,C,D,E} of 5 contracts, which would sell for $10 (plus anytransactions fee) and pay $10 if the interest rate is, respectively,lowered by more than 25 basis points, lowered by exactly 25 basispoints, unchanged, raised by exactly 25, or raised by more than 25 basispoints.

Suppose a retailer, Widco, sells things on credit and typically carries$1,000,000 worth of receivables on its books. Since Widco does not askfor any interest payments on those receivables, they are essentially acontinuously stream of interest-free loans to Widco's customers.Whenever interest rates move up, Widco is incurring additional loss ofinterest payments on these interest-free loans. (In other words,whenever interest rates go up Widco faces a higher cost of doingbusiness while its credit customers do not pay any extra interest fortheir credit line.) Widco would prefer to lock in a constant interestrate so that its profits are more predictable. In particular, Widcobelieves its unhedged change in earnings between August 24-October 15would be:

-   -   (a) $50,000 under a 50 basis point rate decrease;    -   (b) $25,000 under a 25 basis point rate decrease;    -   (c) $0 if the rate does not change;    -   (d) −$25,000 under a 25 basis point rate increase;    -   (e) −$50,000 under a 50 basis point rate increase.

To approximately hedge its interest rate risk exposure, following theHedging Recipe (Eq. 1) given above, Widco would buy from the MarketAuthority:

-   -   (i) 2500 type B contracts=(50,000−25,000)/10;    -   (ii) 5000 type C contracts=(50,000−0)/10;    -   (iii) 7500 type D contracts=(50,000+25,000)/10; and    -   (iv) 10,000 type E contracts=(50,000+50,000)/10.

To put some numbers on the consequences of Widco's hedging position,suppose, for instance, the market believes there is a 35% chance of a 50basis point decrease, 40% chance of a 25 basis point decrease, and a 19%chance of no change, a 5% chance of a 25 basis point increase, and a 1%chance of a 50 basis point increase. Then Widco would pay $10,000(=2500×$10×0.40) for 2500 type B contracts; $9500 (=5000×$10×0.19) for5000 type C contracts; $3750 (=7500×$10×0.05) for 7500 type D contracts;and $1000 (=10,000×$10×0.01) for 10000 type E contracts—for a totalupfront payment of $24,250.

The expected value of Widco's contracts is $1,025,750; but the realizedvalue could be anywhere from a high of $1,050,000 to a low of $950,000.So Widco's unhedged business risk is potentially volatile.

With hedging, after the earnings announcement, Widco's portfolio net the$24,250 upfront payment would be:

Initial Upfront Change In Payoff Of Net Value Of Payment Value OfContracts In Final Value Widco's For B- Widco's Hedge Of Widco'sReceivable E Contracts Receivable Portfolio Portfolio 1,000,000 −24,25050,000 0 1,025,750 1,000,000 −24,250 25,000 25,000 1,025,750 1,000,000−24,250 0 50,000 1,025,750 1,000,000 −24,250 −25,000 75,000 1,025,7501,000,000 −24,250 −50,000 100,000 1,025,750

The first row of numbers show Widco's situation if the interest ratefalls by 50 basis points. In this event, Widco's futures contracts areworthless, but Widco recovers its original $24,250 hedging cost becausethe value of its receivables increases by $50,000. Likewise, the otherrows show Widco's outcome if the interest rate decreases by 25 basispoints or less, remains the same, or increases. In these cases, Widco'sreceivables is changes in value, but the value of the Widco's hedgeportfolio of contracts exactly compensates for Widco's initialinvestment of $24,250 plus the change in value of the receivables.

In summary, regardless of whether the Fed raises or lowers interestrates, the value of Widco's hedged receivables portfolio is locked in at$1,025,750—the ex ante expected value of its receivables portfolio.

Hedging Method Example 3 Real Estate Market

Assume Myron has a house currently worth $400,000 in a San Franciscosuburb. He is concerned that the housing market is overheated and mayfall by as much as 25%. Exactly how can Myron use a contract bundle toprotect himself from this $100,000 exposure? Further assume that aMarket Authority has issued contract bundles {A,B} based on changes inthe real estate index of the San Francisco Bay Area (SFI), where:

-   -   (A) Contract “A” pays off $10 if and only if the SFI does NOT        decrease by more than 0.50 points compared to the previous year.    -   (B) Contract “B” pays off $10 if and only if the SFI decreases        by more than 0.50 points compared to the previous year.

If Myron estimates that there is a 20 percent probability of the SFIfalling by more than 0.5 points, his position value is:

Position Value: Probability (i) $420,000 if the SFI does NOT decrease by0.80 more than 0.50 points (ii) $320,000 if the SFI does decrease bymore 0.20 than 0.50 pointsInitial expected=0.80×$420,000+0.20×$320,000=$400,000

To fully hedge his position, he would buy from the Market Authority:[$420,000−320,000]/10=10,000 type “B” Hedging instruments at a price of$2.00 per Hedging instrument for a total of $20,000

Final Hedged Position:

Initial Upfront expected payment for B Payoff of Net final value HedgingChange in Hedging hedged value of of home instruments home valueinstrument home $400,000 −$20,000 +$20,000     $0 $400,000 $400,000−$20,000 −$80,000 +$100,000 $400,000

Hedging Method Example 3 Becoming Unemployed

Assume, Fisher is a blue-collar worker who is worried about being laidoff from the local GM plant in Lansing, Mich. due to uncertainty in carsales. Fisher makes $40,000 per year and is concerned about that he maybe laid off. He believes that there is a 25 percent chance that carsales will drop by more than 3% in the next three months, which wouldresult in his layoff. He also estimates that it would take three monthsfor him to find another job.

Income Probability $10,000 if car sales do not fall by more than 3% 0.75(3 months salary if Fisher is not laid off)  $2,000 if car sales fall bymore than 3% 0.25 (3 months of unemployment insurance)Expected income=0.75×$10,000+0.25×$2,000=$8,000

In accordance with the principles of the present invention, Fisher mayuse hedging instruments to hedge his perceived $10,000 exposure?” Forexample, suppose a Market Authority offers the a binary contract basedon whether U.S. car sales fall by more than 3% in the next 3 months.That is the Market Authority issues two contracts:

contract “A” that pays off $10 if and only if US car sales do NOT fallby more than 3%; and

contract “B” that pays off $10 if and only if US car sales do fall bymore than 3%

Fisher could fully hedge his position by purchasing from the MarketAuthority: ($10,000−$2,000)/ $10=800 type “B” Hedging instruments at aprice of $2.5 per Hedging instrument for a total of $2,000. Fischersfinal hedged position would then be as provided below:

Upfront Value of Initial expected cost for Hedging Net final 3-month 800B Hedging 3-month instruments at hedged income instruments incomeexpiration income $8,000 −$2,000 $10,000    $0 $8,000 $8,000 −$2,000 $2,000 $8,000 $8,000

Hedging With Contract Splitting

Note that even without hedging, given the implied probabilities, the exante expected value of the hedger's position is p. Hedging does notimprove or—absent transactions cost—lower the expected value of ahedger's position.

What hedging does is change the hedger's actual or realizedoutcome—which could have varied between Q(s1) down to Q(sN)—to aguaranteed, riskless outcome of p dollars. In other words, hedgingchanges the hedger's position from a risky one to a riskless one.

This hedging method is not negatively affected by the possibility ofsplitting and merger since splitting and merger does not affect ahedger's position as long as the hedger does not sell any of thepost-split contracts.

Suppose contract bundles comprised of four contracts each are issuedpertaining to the earnings announcement of Company A in the year-aheadquarter where:

Contract A: payoff $10 if earnings exceeds $0.30

Contract B: payoff $10 if earnings fall within ($0.05,$0.30)

Contract C: payoff $10 if earnings fall within ($0.00,$0.05)

Contract D: payoff $10 if earnings are negative.

The payoff ranges very coarse here because it is hard to predict withany precision earnings 1 year ahead.

However, nine months later, there will be much more information aboutA's earnings. Accordingly, the market will be in a position todifferentiate between contracts based on a finer payoff structure.Suppose at that time that analysts' consensus expects that earnings willbe $0.25. Then splitting contract B into five contracts gives the marketa way to bet on a finer payoff structure, as follows:

-   -   (i) Continue trading contracts A, C, D (they will have very        little value).    -   (ii) Split contract B into 5 contracts where:        -   B1: pays off $10 if earnings fall between ($0.05,$0.10)        -   B2: pays off $10 if earnings fall between ($0.10,$0.15)        -   B3: pays off $10 if earnings fall between ($0.15,$0.20)        -   B4: pays off $10 if earnings fall between ($0.20,$0.25)        -   B5: pays off $10 if earnings fall between ($0.25,$0.30)

In the above approach, following the split, contract B no longer exists.Instead, everyone who owned contract B now owns five contracts, B1-B5and can sell off, piecewise, any subset of B1-B5 they do not want.

Thus, after the splitting process, there are eight contracts trading: A,C, D and B1-B5; these eight contracts form a bundle.

At the discretion of the market authority, splitting can occur at anytime depending on the development of events. The number of new contractscreated by a split is again at the discretion of the market authority.No existing contract owners are hurt by splitting since if they keep allthe new contracts after the split, their post-split position is exactlythe same as their original one. Indeed, owners benefit by a split sincethey have the option to sell away the post-split contracts they don'twant and, by doing so, refine their position(s).

Hedging With Contract Merging

Suppose contract bundles comprised of four contracts each are issuedpertaining to the earnings announcement of Company A in the year-aheadquarter where:

Contract A: payoff $10 if earnings exceeds $0.30

Contract B: payoff $10 if earnings fall within ($0.05,$0.30)

Contract C: payoff $10 if earnings fall within ($0.00,$0.05)

Contract D: payoff $10 if earnings are negative.

As in the previous example, nine months later, there will be much moreinformation about A's earnings. Accordingly, the market will havedifferent expectations based on the new information. Suppose at thatthat time analysts' consensus expects that earnings will be $0.35. Thencontracts B, C, and D will be nearly worthless as the odds of thempaying off $10 is slim. Suppose B, C, and D at that time, respectively,trade for $0.10, $0.05, and $0.01. Moreover, in view of the highlikelihood of them paying off $0 at expiry, owning them is highlyspeculative and, accordingly, they will not be very liquid.

To ameliorate this situation, the market authority can do the following:

-   -   (i) Split Contract A into five contracts where:        -   A1: pays off $10 if earnings falls between ($0.30,$0.32)        -   A2: pays off $10 if earnings falls between ($0.32,$0.34)        -   A3: pays off $10 if earnings falls between ($0.34,$0.36)        -   A4: pays off $10 if earnings falls between ($0.36,$0.38)        -   A5: pays off $10 if earnings exceeds $0.38.    -   (ii) Merge contracts B, C, D to form one contract, E. Upon        merger, contract E will be worth $0.16, the sum of the values of        contracts B, C and D. Contracts B, C, and D continue trading        since traders who own only one or two of these three contracts,        but not all three, cannot trade their contracts in for an E        contract. (If they want to trade for an E, they must first        purchase in the open market contracts to form a complete set of        three contracts.)

Thus, immediately after the split and merger procedures, there are ninecontracts actively trading: A1-A5, B, C, D and E; however, new bundlesare comprised of the six contracts A1-A5, and E. Thus a trader canredeem $10 for either a bundle comprised of A1-A5 and E; or a bundlecomprised of A1-A5 and B, C, and D.

At the discretion of the market authority, merger can occur at any timedepending on the development of real events. The number of contractsmerged into a single contract is again at the discretion of the marketauthority. No existing contract owners are hurt by merger since if theykeep all the new contracts after the merger, their post-merger positionis exactly the same as their original one. Indeed, owners benefit by amerger since merger converts illiquid “penny” contracts into a bigger,usually more liquid contract.

B. Type II (“Coupon”) Contracts

As the name suggests, coupons contracts (or simply “coupons”) are futurecontracts which may be redeemed for a service, product, or ticket (orsome combination thereof, which may itself be a choice of the redeemer).As specified on a contract-by-contract basis, the redemption date orperiod may be set or vary depending on the choice of the coupon holder.Unlike Type I “event” contracts, the payoff of coupon contracts may befixed, or they may be chosen by the coupon holder from a set ofpre-specified possibilities. Moreover, the settlement date for a couponcontract may be at the coupon holder's choice. For instance, a couponfor a restaurant meal, by design, may be redeemable anytime in Februaryfor any meal on the restaurant's menu. A simple scenario follows toillustrate the value of such coupon contracts.

In January 2001, a user purchased nonrefundable San Francisco Symphonytickets for a Stravinsky concert to be held on Feb. 22, 2001.Unfortunately, the user later needed to be out of town that day. Whilethe San Francisco Symphony does permit ticket exchanges (for a $10 fee),as it turns out, all of the San Francisco Symphony concerts of interestto the user for the remainder of the season were sold out. Hence, theuser did not exchange the tickets, and took a 100% loss on the originalamount paid. This unfortunate episode will make the user hesitant to buyadvance tickets in the future.

Coupons settle with the physical delivery of the underlying good orservice. They are essentially continuously tradable claim checks, orcontinuously tradeable newspaper coupons—if newspaper coupons weretradeable (which they are currently not). Coupons may be American orEuropean in style. For instance, a car wash coupon, if American, wouldbe redeemable (at the holder's option) for a car wash at any time.Alternatively, the holder may choose to hold the coupon exclusively fortrading purposes.

It should be emphasized that what distinguishes these coupons fromtraditional newspaper clip out coupons is that every coupon will becontinuously traded in a pre-defined market. In this respect, couponsare more like futures contracts than illiquid newspaper clip out couponsor even their electronic new age cousins. As a result, the value of acoupon is not strictly tied to liquidation—some coupon holders, eitherhedgers or speculators, may be holding coupons purely for resale intothe market. This illustrates how coupons commodify risks in newdimensions.

Part of the preferred embodiment of the present invention includescreating markets for the promotion, sales, distribution, and exchange(trading) of coupons. Coupons can be claims on any product or service.Preferably, coupons are claims on any product or service with anestablished brand, because the brand reassures coupon buyers of qualityand fair play by the producer. Potential products include new books,wine, electronic goods, office supplies, and homes in new housingdevelopments. Coupons can also be created for any other standard event,including four star restaurant meals, hotel rooms, time share vacations,airline tickets, theatre and Super Bowl tickets, any sports eventticket, cruise and vacation tickets, and even Time Square hotel rooms onNew Year's Day.

Transactions with Type II Contracts

While the characteristics and use of Type II (Coupon) contracts will bediscussed further, a full understanding of the types of contracts andthe present invention requires an appreciation of the followingterminology which is used throughout this application:

The “Promoter,” similar to the “Market Authority” is the official agentcharged with the absolute authority and ability—subject to legallimitations—to issue, expire, terminate, buy, sell, or otherwise alterthe nature of the instruments trading in the market, and the marketitself.

A “coupon” is a tradable instrument which pays off, at expiry, aprespecified item of value, which can be anything including goods orservices. For example, the payoff may be a ticket, an option to buy aticket at a predetermined price, a night in a hotel, an option to buyone ticket, and option to buy a ticket to one of two concerts.

“Expiry” refers to the period or time when the coupon may be redeemedfor the payoff object.

Frequently, one may have otherwise identical coupons whose onlydifference is their expiry. For example, Hotel Chain A may sell “onenight stay” hotel room coupons, some which are redeemable only inJanuary, some only in February, some only in March, and so forth. Inorder to guarantee that its rooms are not oversubscribed in January, thehotel would not allow redemption of the March coupons in January or viceversa. The collection of all these coupons would be the “one night stayclass for Hotel Chain A.” All coupons in this class with the same expiryperiod would be referred to as the “Month T coupon series” of thatclass. For instance, “the July series coupon of Hotel Chain A” refers tothe coupons redeemable for a one night stay in Hotel Chain A duringJuly.

In the following, several examples of Type I (Coupon) contracts aredescribed and the manner in which each allows risk to be hedgedexplained.

Example 1 Coupon for a Concert Ticket

The Grasshoppers plan to tour the U.S. in September. In every city, thepromoters face demand risks. How many nights can San Francisco support?Is a 30,000 seat stadium big enough, or is there enough demand tojustify a 55,000 seat stadium? A related risk is price risk; what is themost that fans are willing to pay? Can promoters clear a bigger netprofit by doubling ticket prices? How can promoters foil scalpers?

Potential ticket buyers also face risks. If a customer buys a ticket inJanuary, what if he has an unexpected plans change and cannot go? It istoo much trouble (if not illegal) to try to scalp the ticket. On theother hand, if the customer waits until August to buy a ticket, all thegood seats will be gone. At that time, scalpers will be charging apremium for the few remaining seats.

The apparatus and method according to the present invention provides asolution which is to sell tradable coupons. Tradable coupons eliminatethe liquidity risks faced by early ticket buyers. Buyers who can't gocan easily resell their coupons into the market at the fair, competitivemarket price. Simultaneously, tradable coupons reduce risks faced bypromoters by:

-   -   Allowing promoters to pre-sell tickets earlier since buyers with        no liquidity risk will be more willing to buy earlier and pay        more;    -   Allowing promoters to monitor the trading prices of their        tickets, and hence obtain information about market demand and        pricing, which they can use to set future prices and marketing        strategies; and    -   Eliminating scalpers and other inefficiencies in the ticket        supply chain.

If the Grasshoppers are holding a series of concerts around the country,then they would issue a new class of coupons, one for each city. If theyhold more than one concert in a given city, then they will then issue aseries of coupons for that city, one for each concert. For example, tosee the Grasshopper's second concert in San Francisco, one would buy the“Grasshopper-San Francisco class coupon, series #2” coupon.

Example 2 Coupon for a McDonald's® Meal

As part of its marketing strategy, McDonalds® Restaurant issues a seriesof coupons which are redeemable for a “Complete Meal” consisting of aQuarter Pounder®, a Super Size® fry, an apple pie, and a large softdrink. The series of coupons are monthly, and are issued 3 months aheadof their expiration month. This means that on March 1st, the March,April, and May coupons have been issued, and are trading. The Marchcoupon may be redeemed at any participating McDonalds in March.Likewise, the April and May coupons may be redeemed, respectively, atany participating McDonald's during April and May. (Note: McDonald's®and Quarter Pounder®, are registered trademarks and Super Size® is aregistered service mark of McDonald's Corporation.)

McDonald's benefits from using these coupons in several ways:

-   -   (i) Since it gets cash up front when the coupons are originally        sold, the coupons give McDonald's more control of its cash flow.    -   (ii) The trading activity and prices on the coupons help        McDonald's to gauge the demand curve for its meals three months        in advance. This insight into future demand assists McDonald's        in managing its inventory and marketing strategy.    -   (iii) Coupon trading and redeeming coupons stimulates interest        in eating at McDonald's.    -   (iv) Once a coupon is sold, McDonald's realizes the profit even        if the coupon later expires unredeemed.

Consumers benefit from trading coupons because the consumer is able tolock in meal prices at an earlier date. Tradable coupons are also goodgifts, since the receiver may easily sell them in the market if shedoesn't wish to eat at McDonald's.

Example 3 Coupon for a Pre-Paid Holiday Inn® Hotel Room

Hotels have trouble because their customers don't like them to re-adjusttheir prices and charge a premium during seasonal peak periods. Forinstance, the price for a Holiday Inn® hotel room does not fluctuatemuch during the year, although demand for rooms fluctuates a lot.Clearly, hotels would benefit if they could sell their rooms at a fairmarket value that floats with demand. (Note: Holiday Inn® is aregistered service mark of Holiday Inns, Inc.)

Customers do not like to put down money for “guaranteed” rooms ahead oftime because they might have unforeseen plan changes and not be able touse the room. So customers would benefit by an option to easily resellan unneeded reservation.

Each Holiday Inn hotel could sell its own series of coupons. Each couponwould entitle the holder to a one-night stay in that Holiday Inn on aspecific date. If Holiday Inn wants to allow year-ahead reservations,then it would have a series of 365 coupons, one coupon for each day ofthe year. Every day, one of the coupons in the series would expire, andthe hotel would issue a new coupon for the same day, one year ahead.Note that the hotel does not need to offer every available coupon for adate for sale all at once; it could sell a fraction of the coupons, geta feel for what prices the market is willing to pay, and then sell moreat the new market price.

Example 4 Advance Purchase Order for a Christmas Toy

Producers and developers of new cars, Broadway plays, and condominiumsmust risk incurring huge up front costs without knowing the ultimatedemand for their product. The apparatus and method of the presentinvention can create markets for the promotion, sales, distribution, andtrading of claim checks on advance sales items. Such prepaid claimchecks will be referred to hereinafter as Advance Sales Coupons (ASCs).It should be noted that these markets can either be within a web portaloperated by a hedging service, or be part of the producer's own website, in which case the hedging service will be acting as a co-branderand consultant.

ASCs can be designed for any product. Preferably ASCs are designed for aproduct with an established brand. The brand reassures ASC buyers ofquality and fair play by the producer. Such products include groceries,new books, wine, electronic goods, shoes, office supplies, designerdresses, and homes in new housing developments.

In one aspect of the present invention, a hedging service, which mayoperate a computer network system for selling and exchanging hedgeinstruments, would charge manufacturers and producers an up-front salesand distribution fee for providing a distribution channel for theirASCs. Optionally, the hedging service can levy a per-trade transactionsfee on ASC buyers and traders.

Selling tradable ASCs enables these producers to spread their demandrisk with their potential customers. Also, the market demand for theirASCs provides probably the best information to the producers aboutactual market demand for their product. In return for being willing toassume some of the producer's risk when a customer buys an ASC,customers get a slightly lower price for that new car, movie ticket, orcondo than they would otherwise get by waiting.

Selling tradable ASCs is also a way for producers to finance theproduction of their product. ASC financing may be superior to debt orequity financing, especially if the amount of funds needed is small—toosmall to justify going through traditional banking paperwork.

Historically, customers assume two kinds of risk if they make an advancepurchase order: (i) liquidity risk: risk that their situation maychange, and they do not have the time, money, or inclination to use thebook, movie, or condo when it is ready for consumption two years later;(ii) information asymmetry risk: risk that they are being duped by thepromoter into committing to buy a flop.

By making ASCs tradable, the system and method of the present inventionreduces or eliminates liquidity risk faced by consumers. If an ASCholder's situation changes, she can liquidate her ASC for a fair price.Because of their liquidity, consumers are empowered to buy more ASCs forbooks, movies, and condos they might want to buy two years down theroad.

The system and method of the present invention also reduces informationasymmetry risk by establishing a market price for the ASCs. Customerswho feel they are naive about the potential quality of a new productwill be reassured by an established market price for the ASCs. This isbecause, by market efficiency, market prices reflect the consensusexpectation for the product based on the best publicly availableinformation. Note that producers can also use information in the marketprice of the ASC to determine if they need to improve the quality oftheir final product (e.g. hire a better leading lady for their movie).

As a result, producers and consumers both benefit from ASCs. Forexample, retailers like Amazon or Walmart face much uncertainty whenplanning their inventory orders several months ahead for the ChristmasShopping season. What will be the “blowout” toy next Christmas? If itbecomes very popular, will my toy maker be able to make them fast enoughon short notice? Will the manufacturer raise wholesale prices at thelast minute? How much of this toy should they buy for inventory? Also,Amazon would like to generate more cash flow in the off-season to runoperations and pay salaries.

Given this situation, Amazon would greatly benefit if it couldeffectively spread the Christmas shopping season over the whole year.(Spreading shopping interest throughout the year potentially alsoincreases aggregate shopping interest and hence sales—it has spilloverrevenue-enhancement benefits.) However, shoppers face risks if they buytheir Christmas gifts too early. If one buys a Barbie doll in March, howdo they know their daughter will still want it in December? Maybe shewill develop an interest in piano, in which case the better gift wouldbe some music books.

By establishing a market in Christmas gift ASCs (a distinct ASC seriesfor each toy or toy category), the system and method of the presentinvention addresses both Amazon's and shoppers concerns. Amazon cangenerate cash flow throughout the year by selling new ASCs into themarket. The ASCs' trading prices tells Amazon the market's anticipateddemand for various toys during Christmas. Customers will be willing tobuy ASCs for specific toys in February since they can also resell themback if they change their mind about a toy.

ASCs can be created for any product or bundle of products. For instance,Amazon might sell a booklet of ASCs (one ASC for a Barbie, another ASCfor a book, another for a radio, etc.). Amazon could sell the wholebooklet at a package discount steep enough to attract buyers. Buyers canthen keep the ASCs they want, and re-sell the other ASCs in the thuscreated market. Booklets are a good way for Amazon to stimulate salesvolume.

Example 5 Advance Sales Coupon for New Car

In the Amazon example above, the coupon was for redemption of a productalready in existence. ASCs can also be sold for yet-unproduced items,such as new books, new movies, new wines, or new cars.

For example, suppose Ford is introducing a new luxury line of Sky Spiritautomobiles. Ford's risk is that market demand is volatile, but Fordcannot quickly respond to unexpected changes in demand since it takes 5months to aggregate raw materials and manufacture each car from scratch.Some times, Ford has produced too many cars, which then must be sold ata discount. Other times, Ford has produced too few cars, and lost theopportunity to sell more cars and at higher profit margins.

On the other side of the transaction, customers do not like to commit tobuying a car many months before delivery because of fashion andliquidity risk—not to mention natural procrastination. If it is a brandnew line, the line may turn out to be a lemon. Tradable Sky Spirit ASCshelp solve both Ford and the customers' concerns.

Economic Benefits of Tradable Coupons

Selling tradable coupons enables producers or goods and services toshare the risk of future low demand for their goods or services withtheir customers. Also, the market price for their coupons providesprobably the best information to the producers about actual marketdemand for their product. In return for willingness to assume some ofthe producer's risk when a customer buys a coupon, customers would get abetter market price on the coupon than they would if they wait to buythe good or service at the last minute.

Selling tradable coupons is also a way for producers to finance theproduction of their product. Coupon financing may be superior to debt orequity financing, especially if the amount of funds needed is small—toosmall to justify going through traditional banking paperwork.

For instance, producers and developers of music events, Christmas giftsand new cars risk incurring huge up front costs without knowing theultimate demand for their product. Absent tradable coupons, customerswould assume two kinds of risk if they file a traditional advancepurchase order:

-   -   liquidity risk: risk that their situation may change, and they        do not have the time, money, or inclination to use the book,        movie, or condo when it is ready for consumption later;    -   information asymmetry risk: risk that they are being misled by        the promoter into committing to buy a flop.

By making coupons tradable, the system and method of the presentinvention eliminates liquidity risk faced by consumers. If the situationof a coupon holder changes, she can liquidate her coupon in the thusformed market for a fair price. Because of the liquidity of the coupons,consumers are empowered to buy more coupons for books, movies, condos,and other goods and services they might want to buy down the road.

The system and method of the present invention also reduces informationasymmetry risk by establishing a market price for the coupons. Customerswho feel they are unsure about the potential quality of a new productwill be reassured by an established market price for the coupons. Thisis because, by market efficiency, market prices reflect the consensusexpectation for the product based on the best publicly availableinformation. Note that producers can also use information in the marketprice of the coupon to determine if they need to improve the quality oftheir final product (e.g., hire a better leading lady for their movie).As a result, producers and consumers both benefit from coupons.

For instance, in regard to the example above for sales of Grasshopperconcert tickets, Promoters would benefit from a system in accordancewith the apparatus and methods of the present invention in the followingway. The Promoter can “test” the market by putting up, say, 5000 futurescoupons for sale in January for “IPO” price of $25. Suppose the originalIPO batch trades at a market price of $38 in February. Then the promotercan slowly offer additional coupons for sale at the new market price($38). At the same time, the promoter can also adjust his retailadvertising campaign to try and improve the market price. The promotermight choose to ultimately sell all or just a fraction of the seats viaour futures market. (Of course, the promoter will have trouble sellingtickets for higher than the price buyers can get from the futuresmarket.)

The promoter benefits since the continuous market action informs thepromoter about the demand for his product, and thus how much consumersare willing to pay. Consumers, in turn, are more willing to buy futuresin January since they can easily resell (perhaps even at a higher price)if they change their mind about attending. If sales go well (or not),the promoter might even be able to move the concert to a bigger orsmaller stadium. Finally, the market puts third party scalpers out ofbusiness.

Similarly, consumers benefit in the above-described situation. Consumerswill be eager to buy their seats in January at the lower IPO price,since they can always resell later if they cannot attend the concert.Latecomers also benefit from the market price, since they can always buyfrom the market by meeting the latest ask price. Effectively, theconcert is never sold out since one can always buy a ticket by meetingthe then-prevailing market ask price.

Description of Type II Contract Markets

The following terminology and concepts pertain to market transactionsinvolving Type II contracts. It will be appreciated that there is someoverlap to the terminology and concepts pertaining to markettransactions involving Type I contracts.

A “trader” is any person authorized to buy or sell, or to make offers tobuy or sell, coupons in the market.

A “Promoter” is a special trader who has the power to issue its owncoupons for sale. Like any other trader, promoters may also trade couponin the market by meeting bid/ask prices in the market.

“Sale of a coupon by the Promoter”—When the promoter authorizes a newseries of coupons for trading, it initializes the market by offering tosell to traders, at a stated offering price, coupons of that series. Thepromoter is not obligated to sell all its coupons at once, or to offerthem for the same price. For instance, the promoter may sell the first500 coupons at one price; wait a few days; offer to sell an additional1000 coupons at a different price (which may reflect demand for thefirst 500 coupons); wait a week; offer to sell additional coupons, etc.Promoters may also offer to buy back coupons at stated prices from themarket. Of course, market participants are not required to accept thepromoter's offer.

“Active redemption of coupons by the promoter”—In certain cases,promoters may design the coupon so that it always has a right, but notan obligation, to buy back all coupons at a pre-stated price. Promotersmay do this, for instance, if it anticipates a possibility that it maywant to cancel an event. Then, to cancel the event, the promoters wouldsimply buy back all the coupons, which relieves them of the obligationto settle the coupons at expiry.

“Limit order for purchase of a coupon”—The only orders traders may placeto buy or sell individual coupons are limit orders. A limit order topurchase a contract A is an outstanding offer to buy at a certain pricefor a certain period of time. The offer must specify:

-   -   numbers of A coupons desired    -   maximum price per A coupon the aspiring buyer is offering    -   an expiration date after which the offer terminates.

Acceptance of an outstanding limit order is binding on the offeror. Theorder is automatically withdrawn at 12.01 a.m. of the expiration date.However, traders may cancel their limit order at any time prior to theirstated expiration date by placing a cancellation order.

“Limit order for sale of a coupon”—A limit order to sell a coupon is anoutstanding order specifying:

-   -   quantity of coupons offered for sale    -   minimum price per coupon demanded    -   an expiration date after which the offer terminates.

Acceptance of an outstanding limit order is binding on the offeror.However, traders may cancel their limit order at any time prior to theirstated expiration date by placing a cancellation order.

Components of Coupon Markets

At any given instant before expiry, any coupon market will preferablyconsist of the following:

-   -   a promoter who may (at its own discretion) sell additional        coupons to or buy back coupons from the market    -   a collection of traders' accounts qualified to transact in this        market; that is, a collection of accounts qualified to place        limit and buy orders on this coupon    -   a queue of limit orders to buy coupons, preferably arranged in        priority according to the following criteria in order of        importance:        -   price per coupon (highest order first)        -   number of coupons offered (greatest quantity first)        -   time order was entered (earliest order first)    -   a queue of limit orders to sell coupons, preferably arranged in        priority according to the following criteria in order of        importance:        -   price per coupon (lowest price first)        -   number of coupons offered (greatest quantity first)        -   time order was entered (earliest order first), and    -   a mechanism for communicating to all traders' accounts timely        information about the status of the market, including the price        and volume information of recent trades, and the best limit        prices and quantities in the limit buy and sell queues

C. Type III (“Firm-Issue” and “Intra-Industry”) Contracts

Firm-Issue and Intra-Industry Contracts are custom-tailored contractsdesigned in consultation with industry and firm partners. They aredesigned to enable one or more firms within one or more specificindustries to manage and/or share risks. For instance, a manufacturermay manage its inventory risks by issuing tradable coupons to itsdistributors as a means of pre-selling wholesale inventory to its retaildistributors. Similarly, a loose confederation of firms may useintra-industry contracts to diversity their receivables portfolios, andreduce the seasonality of their cash flows. Firm-issue andIntra-industry contracts may be written on events or prices ofnoncommodity or inventory manufactured items. Tailored to the needs ofthe firms, they may be American or European, settle on cash, goods, orservices and—depending on specific needs—may have exotic path-dependentpayoff rules.

Since the clientele for firm-issue and intra-industry contracts isrestricted and sophisticated, embodiments of the invention will usuallyinclude working with clients to specifically tailor and design contractsthat meet individual needs. Firm-Issue and Intra-Industry contracts mayalso be referred to hereinafter as “restricted clientele” contracts.

Companies carry many risks such as those inherent in receivables, cashflow, supply chain and inventory management. A Market Authority actingin accordance with the present invention can help firms hedge theserisks by designing firm-specific hedging contracts for these firms.

Relative to Type III contracts, a Market Authority would act as a firm'sinvestment banker, and help the firm design, market, and sell (IPO) itshedging instruments into the thus created market or set up an internalfirm-Specific or intra-industry futures markets for (1) supply chainmanagement or (2) risk-sharing management. A business acting inaccordance with the present invention could charge firms an up-frontconsulting fee and set up for these services, plus an on-going “marketmanagement” fee. The market-management fee could be per-transaction or aflat fee.

Supply Chain Management

To determine how much to manufacture or buy for inventory, manufacturersand retailers like to solicit “advance purchase orders.” These prepaidcontracts are redeemed for delivery of a product or service at a laterdate. However, such contracts are unattractive to customers since theyforce early customers to forecast future needs and assume the riskassociated with early precommitment. But without precommitment from itscustomers, manufacturers and retailers face costly returns of unsoldinventory.

One form of Firm-Specific and Intra-Industry Contracts are advancepurchase orders on any product, cash amount, or service with anestablished quality that are tradable between a pre-qualified group oftraders. The ability to trade them dramatically enhances the value ofadvance purchase orders to both the issuers and customers. Theunderlying products may include raw materials, intermediate goods, aswell as wholesale consumer items. Wholesale consumer items may includenew books, wine, electronic goods, office supplies, as well assemi-commodity items such as semiconductor chips, copper wire, photocopypaper, solar energy, and cable TV time. Finn-specific and Intra-IndustryContracts settle with the physical delivery of the underlying goods orservices.

The thing that distinguishes Finn-Specific and Intra-Industry Contractsfrom Type II coupons is that the trading and holding of Firm-Specificand Intra-Industry Contracts are restricted to a pre-qualified set oftraders.

Components of Firm-Specific and Intra-Industry Contract Markets

A Firm-Specific and Intra-Industry Contract is a tradable instrumentthat pays off at expiry a prespecified inventory item. The inventoryitem may be a commodity, a semi-commodity, or a specific product ofmanufacture. For example, the payoff may be a batch of 500 semiconductorchips, a ton of a given grade of high grade aluminum, a gallon of aspecific grade of gasoline, a dozen Nike shoes of a given size anddesign, one dozen copies of the next year's Microsoft Windows operatingsystem, or 100,000 banner ad displays on Yahoo!

“Expiry” refers to the period or time when the Firm-Specific andIntra-Industry Contracts may be redeemed for the payoff object. Asspecified on a contract-by-contract basis, the redemption date or periodmay be set or vary depending on the choice of the contract holder.Unlike Type I “event” contracts, the payoff of Firm-Specific andIntra-Industry Contracts may be fixed, or they may be chosen by theholder from a menu of possibilities pre-specified by the issuer.Moreover, the settlement date for a Firm-Specific and Intra-IndustryContracts contract may be at the contract holder's choice.

A “qualified trader” is any person authorized to buy or sell, or to makeoffers to buy or sell for a specific Firm-Specific and Intra-IndustryContract. A trader must specifically and separately qualify to trade ineach Firm-Specific and Intra-Industry Contract. The qualifications fortrading in a particular contract is determined by the Market Authority.

A “promoter” is a specially qualified trader who has the power to issueits own Firm-Specific and Intra-Industry Contracts for sale. Like anyother qualified trader, promoters may also trade Firm-Specific andIntra-Industry Contracts in the market by meeting bid/ask prices in themarket.

Sale of a Firm-Specific and Intra-Industry Contracts by the Promoter

When the promoter authorizes a new series of Firm-Specific andIntra-Industry Contracts for trading, it initializes the market byoffering to sell to qualified traders, at a stated offering price,Firm-Specific and Intra-Industry Contracts of that series. The promoteris not obligated to sell all its Firm-Specific and Intra-IndustryContracts at once, or to offer them for the same price. For instance,the promoter may sell the first 500 Firm-Specific and Intra-IndustryContracts at one price; wait a few days; offer to sell an additional1000 Firm-Specific and Intra-Industry Contracts at a different price(which may reflect demand for the first 500 Firm-Specific andIntra-Industry Contracts); wait a week; offer to sell additionalFirm-Specific and Intra-Industry Contracts, etc. Promoters may alsooffer to buy back Firm-Specific and Intra-Industry Contracts at statedprices from the market. Of course, market participants are not requiredto accept the promoter's offer.

Active Redemption of Firm-Specific and Intra-Industry Contracts by thePromoter

In certain cases, a promoter may design the Firm-Specific andIntra-Industry Contracts so that it always has a right—but not anobligation—to buy back all Firm-Specific and Intra-Industry Contracts ata pre-stated price. A promoter may do this, for instance, if itanticipates a possibility that it may want to cancel a product. Then, tocancel the product, the promoters would simply buy back all theFirm-Specific and Intra-Industry Contracts, which relieves them of theobligation to settle the Firm-Specific and Intra-Industry Contracts atexpiry.

Limit orders for Type III contracts work just like limit orders forTypes I and II, which have been described above.

At any given time before expiry, any Firm-Specific and Intra-IndustryContracts market will consist of the following:

-   -   a promoter who may (at its own discretion) sell additional        Firm-Specific and Intra-Industry Contracts to or buy back        Firm-Specific and Intra-Industry Contracts from the market    -   a collection of qualified traders' accounts qualified to        transact in this market; that is, a collection of accounts        qualified to place limit and buy orders on this Firm-Specific        and Intra-Industry Contracts    -   a queue of limit orders to buy Firm-Specific and Intra-Industry        Contracts, arranged in priority according to the following        criteria in order of importance:        -   price per Firm-Specific and Intra-Industry Contracts            (highest order first)        -   number of Firm-Specific and Intra-Industry Contracts offer            (greatest quantity first)        -   time order was entered (earliest order first)    -   a queue of limit orders to sell Firm-Specific and Intra-Industry        Contracts, arranged in priority according to the following        criteria in order of importance:        -   price per Firm-Specific and Intra-Industry Contracts (lowest            price first)        -   number of Firm-Specific and Intra-Industry Contracts offer            (greatest quantity first)        -   time order was entered (earliest order first)    -   a mechanism for communicating to all qualified traders' accounts        timely information about the status of the market, including the        price and volume information of recent trades, and the best        limit prices and quantities in the limit buy and sell queues.

Example 1 Inventory Futures for Supply Chain Management

Nike faces a persistent “supply chain” problem for its designer shoes.If a shoe store in Germany orders 1000 pairs of a particular design, ittakes Nike several months to buy the raw materials, manufacture that lot(usually in an Asian factory), and transport it cost effectively(usually by cargo ship) to Germany. The problem is compounded because(i) Nike has outlets all over the world; (ii) the popularity ofdifferent designs vary greatly around the world; (iii) fads change ingeographically-idiosyncratic ways in different geographical markets. Forinstance, a German store might believe in March that red Michael Jordandesigns will become popular next Christmas and order 1000 pairs.However, in September it turns out that white shoes are the rage inGermany, and the German store can no longer sell the red shoes. However,suppose a red shoe fad takes hold in Brazil, and a Canadian outlet iswilling to cancel its order of 500 pairs of white shoes—for the rightprice.

What is the most efficient way to reorganize this contractualarrangement so that the German outlet gets the white shoes, theBrazilian outlet the red shoes, and the Canadian outlet the right size?

Like other businesses, Nike has tried to solve its supply chain problemusing Electronic Data Interchange (EDI). EDI is a form ofbusiness-to-business (B2B) intranet. However, EDI cannot efficientlysolve the German-Brazilian-Canadian problem above. While the EDI modelenables outlet stores to shorten the waiting time between their ordersand receiving their goods, the wait time is still over one month. Thisis why there are frequent shortages of popular shoe brands, andoverstocking of other brands. For the rush Christmas season, Macy'sneeds to place orders in September or October. And once orders arelocked in, Macy's cannot cancel or change its order without causingsomebody to suffer transactions costs. Even worse, Macy's loosescustomers, reputation, and profits whenever it cannot supply the hottestdesigns in a timely manner.

A Market Authority acting in accordance with the present invention canenable Nike to solve its supply chain management problem by setting upan internal futures market where Nike's wholesale customers (theindividual stores of Macy's, Walmart, LLBean, Sears, etc.) can tradeadvance Firm-Specific and Intra-Industry Contracts between themselves.Instead of arranging individual supply contracts with Nike, every outletgoes to the futures market and buys the contracts it anticipates itneeds. The outlets which are willing to pay the most for a particulardesign will buy it in the market (that is, the German outlet will offerhigher prices for the white shoes contracts because of local demand, andwhen the price is high enough, the Canadian outlet will sell them—evenif there is a moderate amount of local Canadian demand). At the sametime, the German firm can sell its red shoes contracts to the Brazilianfirm at the market price. The futures prices are determined by marketforces and are fully liquid.

Moreover, prices of the various contracts inform Nike of marketconditions in real time. So, if Nike sees that the price of a particularcontract is increasing, it learns there is unmet demand for that type ofshoes. Based on this real-time information, Nike can choose to increasesupply and issue more contracts—but only if it is feasible andprofitable for it to do so taking into account the market price and itscost of production.

Note: Nike gets paid for the shoes immediately upon sales of its futurescontract into the market, and the contracts are only redeemable forshoes, not cash.

Example 2 Mutual Fund Cash Flow Management

Open end mutual funds have problems with cash flow. In such funds,investors have the right to buy or redeem more shares at will.Therefore, depending on market sentiment, these funds face either massredemptions (and thus a cash shortage) or mass purchases (and thus cashsurpluses due to excess inflows of investor cash). These wide swings incash force mutual funds to alter their investment behavior. When theyhave a cash shortage, they are forced to sell shares. When there is acash surplus, funds are pressured to make additional investments.However, these forced sales and purchases may be suboptimal. Forinstance, when the market crashes, investors tend to redeem theirshares, which forces mutual funds with long positions to sell equity atlower prices that they otherwise would want to.

There are widely publicized indices which measure net cash inflow (NCI)or redemptions each month. Based on these indices, a Market Authorityacting in accordance with the present invention could create bundles ofcontracts like the following:

-   -   A contract A which pays $10 if NCI is positive and $0 otherwise;    -   A contract B which pays $10 if NCI remains steady and $0        otherwise;    -   A contract C which pays $10 if NCI becomes negative and $0        otherwise.

Note that while the structure of this particular contract is like theType I contracts, and A, B, and C together form a riskless bundle, notall Firm-Specific and Intra-Industry Contracts will be of this form.Thus, mutual funds that go long can smooth their NCI by buying contractC and Mutual funds that go short can smooth their NCI by buying A.

Banks, which are required by law (FDIC) to maintain a certain level ofliquid cash on hand to enable depositors to withdraw their money, canuse analogous contracts to insure a steady cash flow.

Example 3 Risk-Sharing Management

Firms A, B, and C are insurance companies that are liable for $1.0billion of housing reconstruction in event of an earthquake in LosAngeles and firms X, Y, and Z are housing construction companies in LosAngeles.

Firms A, B, and C are risk complements to X, Y, and Z in the followingsense. While an earthquake is financially devastating for A, B, and C,they create windfall profits for X, Y, and Z. A, B, and C and X, Y, andZ could reduce their financial volatility by pooling their risks sothat, regardless of whether an earthquake occurs or not, each areguaranteed a median outcome.

These six firms can hedge each other's risk by forming a private marketto trade the following two contracts:

-   -   Contract I which pays $10 if there is a 7.0 or greater        earthquake in Los Angeles during year 2002, and $0 otherwise.    -   Contract II which pays $10 if there is not a 7.0 or greater        earthquake in Los Angeles during year 2002, and $0 otherwise.

While these six firms may use a generic (publicly traded) earthquakecontract to hedge, there are many reasons why A, B, C and X, Y, Z mayprefer to trade between themselves in a private, industry-limitedmarket. For instance, because the sums of payoff money involved are verylarge ($1.0 Billion), they may not want to use the pay-up-front bundlesmodel. Instead, they may want to contract just between themselves,without prepayment, in which case credit risk and the identity of thequalified traders is important. Also, for competitive reasons, they maynot want the price of the contracts to be publicly disclosed. So aMarket Authority acting in accordance with the present invention canhelp them to create custom-tailored “club-only” futures markets fortheir own industry consortium.

Other examples of risk-complement industries include:

-   -   public transportation verses auto manufacturers    -   airlines and oil companies    -   telephone modem manufacturers, DSL providers, and cable modem        service providers    -   ice cream manufacturers and hot chocolate manufacturers    -   network computer manufacturers and traditional computer        manufacturers    -   genetic therapy firms and traditional drug manufacturers    -   brick and mortar retailers verse Internet retailers    -   banks and brokerage houses    -   alternative energy suppliers verses traditional utilities.

Example 4 Egghead-Onsale Cash Flow Futures

Egghead-Onsale is worried that if things do not go well in the nextquarter, it may have cash flow liquidity problems. It is too late to bedoing a new SPO (in any case, management would prefer not to dilute theshares), and the interest rate that banks are demanding for debt isunattractive.

If there is no hedging and things go well (50% chance), Egghead-Onsalewill have $11 million dollars of cash at the end of the quarter. Ifthings do not go well (50% chance), Egghead-Onsale will be $1 milliondollars in the red.

Egghead-Onsale would prefer to lock-in a riskless cash balance of $5million. To do this, a Market Authority acting in accordance with thepresent invention can help Egghead-Onsale by constructing the followingcontracts:

-   -   Contract I which pays $10 if Egghead-Onsale has more than $10        million dollars cash as reported on its audited financial        statements for year-end 2002, and $0 otherwise.    -   Contract II which pays $10 if Egghead-Onsale has between $0 and        $10 million dollars cash as reported on its audited financial        statements for year-end 2002, and $10 otherwise.    -   Contract III which pays $10 if Egghead-Onsale has less than $0        cash as reported on its audited financial statements for        year-end 2002, and $0 otherwise.

In the simplest design, a Market Authority acting in accordance with thepresent invention will issue these contracts into the market.Egghead-Onsale will establish long positions on both Contracts II andIII according to the hedging recipe (Eq. 1) given above for Type Icontracts.

Other examples include rent payment futures for office complexes andfutures on property resale prices.

Example 5 Receivables Futures Example

Suppose that Sun Microsystems (“Sun”) sells hardware to Internetstartups on a long term credit basis, and that it now has $1.0 billionof receivables on its books. Sun expects that about 10-20% of thosereceivables will not be collectible since some of its customers willdeclare bankruptcy. Sun would be willing to sell its $1 billion of riskyreceivables for $850 million cash. By designing and trading futurescontracts that pay off depending on how much of the $1.0 billion iscollected, a Market Authority acting in accordance with the presentinvention can help Sun sell its portfolio for $850 million cash.

Economic Benefits of Tradable Firm-Specific and Intra-Industry Contracts

Using the example above of Nike shoes, Nike benefits from numerous waysfrom the futures markets:

-   -   Nike can “test” the popularity of each shoe design by first        putting up, for instance, 5000 futures contracts for sale in        January for “IPO” price of $25. Suppose the original IPO batch        trades at a market price of $38 in February. Then Nike can        gradually offer additional contracts for sale at the new market        price ($38).    -   At the same time, Nike can monitor which geographic location is        buying which type of contract and, therefore, gain insight into        the fads for that year and use this information to focus its        advertising campaign and production schedule.    -   Nike has the discretion ultimately to sell all or just a        fraction of each shoe via the futures market.    -   At its discretion, Nike has an American option to repurchase its        own contracts from the futures market if it decides delivery of        the shoes is not in its own best interest.    -   This “self-organizing” market mechanism reduces Nike's sales        staff and administrative overhead.

The retail outlets also benefit. Outlets, in turn, are more willing tobuy Christmas futures early in the year since they can always resell ifthat particular design is not popular in their region.

Also, if a fad breaks out in Brazil for red Nike shoes, the Brazilianoutlet will be willing to pay more for the red shoes futures; as aresult, both the German seller and the Brazilian buyer benefits. Inother words, the outlets share in the more efficient allocation of theshoes through trading the futures.

One of ordinary skill in the relevant art will appreciate that analogouscontracts can be created for any other inventory semi-commodity productin any industry.

While several types of contracts have been described, and examples ofeach given, the present invention is not limited to methods andapparatus for trading only these types of instruments. Instead, thepresent invention is directed to a method and apparatus that can createa risk hedging marketplace and is not limited by the types of riskinstruments which can be traded there.

II. The Contract Trading System

As noted in the summary of the invention, an objective of the presentinvention is to enable and provide a new form of risk hedging. The firstsection of this specification addressed the various hedging contracts orinstruments, the sale and transactions which are a necessary adjunct tothe inventive process and apparatus. Having defined and described someof the types of risk hedging instruments which can be sold and traded tohedge risk, the discussion will now address preferred embodiments of themethod and apparatus according to the present invention.

A preferred embodiment of the present invention will be described nextin reference to the various figures. A preferred embodiment of thepresent invention is configured as an Internet-based web server, whichprovides a world-wide-web (WWW) accessible user interface and softwareto implement the unique functions of the present invention.

FIG. 1 shows a general internet-based webserver which implements thepresent invention. Main Computer 100 is connected either directly, orindirectly via a local-area network (LAN) or wide-area network (WAN), tothe Internet 200. Main Computer 100 is programmed with webserversoftware 400 so as to be able to (i) serve data out in response toreceived Internet user requests; (ii) accept account login and otheraccount management and trade instructions from Internet users; (iii)communicate users' instructions to the trade engine and computersassociated with the trade engine; and (iv) serve data and respond toinstructions from the Market Authority 500. The Web Server Software 400,Market Authority 500, Account Management Engine 600, Trade Engine 300,Market Database 390, Account Database 610 and Clearance and Settlement690 will be discussed later. Note, while the Market Authority 500, TradeEngine 300, Account Management Engine 600 and other functions are shownin FIG. 1 as being directly attached to Main Computer 100, each of thesefunctions can also be connected to the Main Computer 100 indirectly viaa LAN, WAN, Internet or other computer connection. Moreover, eachfunction may be provided by one computer or distributed over multiplecomputers, and any given computer may provide one or more functions.

In FIG. 1, the market database 390 is designed to collect and organizeexchange data. This data will not include any private information suchas member identification, but will consist primarily of executed tradeprices and volumes. The majority of this information will be availableto members and reported to government regulatory authorities inaccordance with applicable regulations. Further, the governmentregulatory authority may require access to all of this informationshould it deem such access necessary for surveillance or other purposes.Information will be available on all orders placed on the system inorder to provide members with histories and data points as to the stateof various contract markets.

The Account Database 610 contains data on individual members and theiraccounts, which allow the Account Management Engine 600 to function. Byway of example, and not limitation, the Account Database 610 preferablyconsists of at least the following items of information:

-   -   information identifying each member, including his or her name,        account number, web login name, login password, any other        account-related IDs or secret passwords;    -   member contact information (e.g., mail, Email, telephone        number);    -   status of the account (e.g., active, suspended, deactivated);    -   history of the account, including activation date(s), suspension        history, dates and amounts of all money transfers, dates and        amounts of all market transactions, dates and description of all        bids and offers entered, dates and amounts of all transactions        with the settlement bank, dates and amounts of all interaction        with the Market Authority 500, dates and balances at each date,        and any remarks about the account entered by the Market        Authority 500.

FIG. 2 shows an expanded view of the Market Authority 500. The MarketAuthority 500 contains a New Instrument Application 510. The NewInstrument Application 510 is used to introduce new and differenthedging instruments to the exchange (i.e., new types of contracts to betraded). It will enable authorized personnel to, among other things,inform members of new instruments, post messages regarding the terms andconditions of new instruments, and list new instruments on the market.

Specifically, the New Instrument Application 510 will provide thecapability for both Members 10 and the Market Authority 500 to designand list new instruments as well as modify existing instruments. Duringoperation of a market according to the present invention, preferably theMarket Authority and its members will be continually developing newinstruments for the exchange. The New Instrument Application 510 allowsusers to quickly define critical components of a contract, thus enablingthe rapid rollout of millions of potential instruments. The NewInstrument Application 510 provides an easy to use interface throughwhich the terms of a contract are identified, described, and defined andwhich are then sent to the appropriate market administrative personnelfor approval. Upon approval, the new instrument is preferablyimmediately listed in the portal, trading, and clearing systems,however, the system can also provide for a delayed listing of newinstruments. For example, and not by way of limitation, the NewInstrument Application 510 may require the following information for anew instrument:

-   -   Tracking Information: e.g., Contract Id Number Etc.    -   Ownership Information    -   Underlying Event or Item    -   Unit of Original Issuance    -   Contract Bundle Issuance & Redemption Price    -   Contract Payout Criteria    -   Unit of Trading: e.g., 1 Contract    -   Contract Price Quotation    -   Min. Price Increment: e.g., $0.01    -   Max. Contract Duration: e.g., 1 Yr    -   First Trading Day    -   Last Trading Day    -   Trading Hours: e.g., 24×7×365    -   Expiration Date: e.g., 2 Days After Last Trading Date    -   Settlement Date: e.g., 2 Days After Expiration Date    -   Expiration Value    -   Settlement Value    -   Settlement Method

The market authority 500 contains two additional applications: anAdministrative Application 520 and a Surveillance Application 530. TheAdministrative Application 520 will allow administrative personnel to:

-   -   undertake limited inquiry into all market transactions;    -   suspend and resume trading in particular contracts or the market        as a whole;    -   suspend and resume or terminate account privileges based on the        rules of the exchange;    -   suspend contract payouts in the event of an emergency or some        other eventuality detailed in market rules;    -   amend and override calculated settlement prices and redistribute        funds in the event of an unforeseen system error or an event        identified in the rules of the exchange; and    -   distribute announcements to all or selected market participants.

The Surveillance Application 530 will provide compliance staff withview-only access to all current and historic transaction data input intothe exchange by members, from order placement to message posting on theelectronic bulletin boards. The system will be programmable to drawattention to specific events of interest to the compliance staff. Thesystem allows the staff to investigate specific transactions and tradepatterns and will permit the staff to view member identificationinformation along with order information. More specifically, theSurveillance Application 530 will allow the staff to:

-   -   view the complete depth of the market for all contracts (i.e.,        the listing of all pending bid and offer orders);    -   view the details of all transactions including counter-party        identities, which are hidden from market participants;    -   view all electronic bulletin board postings;    -   define and track a set of alerts that will highlight the        occurrence of specific events and transaction patterns; and    -   investigate any alerts or activity that has potential to violate        rules of the exchange.

FIG. 3 shows an expanded view of the Clearance and Settlement 690function. The Clearance and Settlement 690 function includes theClearance Application 692, Settlement Bank 694 and Settlement Interface696.

As depicted in FIG. 3, one component of Clearance and Settlement 690 isthe Clearing Application 692. As the sole clearing agent for theexchange, the Clearing Application 692 enables the Market Authority 500to monitor all transactions and record all transaction data necessaryfor the clearing and settlement of every trade on the exchange. ClearingApplication 692 gives the Market Authority 500 access to member specifictransaction data including member account information as well as thedetails and status of all orders. Further, the Clearing Application 692will communicate with the Settlement Bank 694 to provide instructions,review settlement account information for all members, and reconcileclearing information with settlement account information.

The second component of Clearance and Settlement 690 is the SettlementInterface System 696. The Settlement Interface System 696 will be thelink through which the trading system communicates with the SettlementBank 694 (See also FIG. 7). The Settlement Interface System 696 willwork with the various components of the MOPS (See FIG. J) and theClearing Application 692 to automatically provide instructions to theSettlement Bank 694 such as blocking funds needed to execute anoutstanding trade, moving funds between accounts due to purchases andsales of contract bundles and contracts, and crediting funds to accountswhen in-the-money contracts expire. Settlement Interface System 696queues instructions in chronological order and either (i) sends thequeue in batch mode to the Settlement Bank 694 for processing atintervals throughout the day, or (ii) maintains continuous, real-timesettlement through an on-line bank. The settlement interface will alsoperform periodic tests to ensure that the clearing records maintained bythe Account Management Engine 600 are consistent with the settlementaccount records maintained by the Settlement Bank 694. If there are anydiscrepancies, Account Management Engine 600 will take all necessarysteps to accurately reconcile the two records. To ensure maximumefficiency and reliability, the Settlement Interface System 696 isdesigned in cooperation with the Settlement Bank 694.

As illustrated in FIG. 3 and as described below, the Market Authority500 will preferably maintain three types of accounts with one or moresettlement banks. The first type of account is a Custodial Account 695a, which the Market Authority 500 maintains for each of its members.These accounts are for the benefit of the individual members and allfunds and instruments held in these accounts will be owned by themember. However, these accounts will respond only to the instructions ofthe market clearing system. The second type of account is a MarketAuthority Account 695 b, which is a proprietary account that will holdall unencumbered funds owned by the Market Authority 500. This is theaccount into which trading fees, structuring fees and the like aredeposited. The third type of account is a Settlement Account 695 c whichis essentially an escrow account. Proceeds from the sale of bundles aredeposited into the settlement account and are held there until theexpiration of the contracts which make up that bundle. Upon expiration,these funds are used to pay off in-the-money contracts.

FIG. 4 shows a general top level web-site design in accordance with apreferred embodiment of the present invention. FIG. 4 generallyillustrates the main levels of the website and identifies some of thecategories of pages which are provided in the preferred embodiment. TheHome Page 410 is the front page to which new and some existing userswill go as the starting point for interacting with the present system.Home Page 410 provides links down to pages at lower levels. At a levelbelow Home Page 410 are: Log In Page 420, to which registered users goto log in (some registered users may prefer to use Log In Page 420 astheir initial page); Public Pages 470 contain general introductory andadministrative information about the site for users (see FIG. 6); NewUser Registration Page 450, which provides online registration forms andinformation for prospective registrants (see FIG. 5); My Account Page422, which is the customizable home page for a registered user who haslogged in; Contract Center Page 424, which provides a list—by event orsubject matter—of contracts being traded and a pathway for users toaccess a catalogue of contracts via the Underlying Info and ContractsPage 430; and Underlying Info and Contracts Page 430, which provides anorganized catalogue of contracts being traded, including links toupdated market data pertaining to trading activity on each contract.

Each contract has a corresponding electronic bulletin board or Chat Page432 to which users can post information and voice personal opinions; aNews Page 434 which contains recent pertinent news feeds from commercialwire services; Executive Summary Page 436 and General Reports Page 438which contain summary historical and background information on recenttrading, price, and volume activity on the contract. Each contract alsohas a corresponding Contract Description and Order Form Page 440. Fromthe Contract Description and Order Form Page 440 the user may access aDetail Terms and Conditions Page 442, and an Order Confirmation Page444, should the user elect to execute an order using the order form.

The Executive Summary Page 436 for each contract bundle will displayreal time quotes for the best bid and offer for each contract in eachoutstanding series of the contract bundle. The Executive Summary Page436 will also show the expiration date for each outstanding series, thepayout criterion for each contract, and the current rate, level, orvalue of the underlying. The Executive Summary Page 436 will also allowthe member to hyperlink to the rules describing the contract bundle andcontracts, charts showing the trading history of all the contracts, anda glossary of terms related to the contract bundles, contracts, and theunderlying.

FIG. 5 shows an expanded view of the pages which are located below theNew User Registration Page 450. Specifically, below the New UserRegistration Page 450, are Observer Basic Info (1) Page 452 and MemberBasic Info (1) Page 460. Beneath Observer Basic Info (1) Page 452 arethe Service Agmt. Page 454 and the Open Acct. Confirmation Page 456.Beneath Open Acct Confirmation Page 456 are the Contract Center Page 424and Getting Started Page 458.

Similarly, beneath the Member Basic Info (1) Page 460 are the Method ofDeposit (2) Page 462, the Source Acct. Info Page 464, the Service Agmt.Page 466, and the Open Acct. Confirmation Page 456. Note that there aresome pages, such as the Open Acct. Confirmation Page 456, which can beaccessed by more than one page. Beneath the Open Acct Confirmation page456 are the Getting Started Page 458, the My Account Page 422, and theContract Center Page 424, all of which are accessible from other pages.

FIG. 6. shows an expanded view of some of the pages that belong to thePublic Pages 470, which are located below the Home Page 410.Specifically, below the Home Page 410 are: the Introduction Page 472;the FAQ Page 474; the Media Page 476; and the About The Company Page478. As noted in regard to FIG. 5, other pages which are located belowthe Home Page 410 are the Log In Page 420 and a New Users RegistrationPage 450. Below the Introduction Page 472 are: the Overview Page 480;the Description of Contracts Page 482; the Exchange Page 484; and thePage About You 486. Below the About The Company Page 478 is the ContactUs Page 488, which provides information about how retail users cancontact the company.

FIG. 7 shows a flow chart of a member interacting with the Trade Engine300 function of FIG. 1. Specifically, as shown in FIG. 7, a Member 10accesses the Trade Engine 300 via a computer connection such as theInternet and the Web Server Software 400. When the Member 10 places anorder via the Order Placement Application 310, the order is verified bythe Validater 320. If the order is accepted, it is routed to the OrderRouter 330.

As depicted, the Order Placement Application 310, the Validater 320, theOrder Router 330, the Order Matcher 340, the Settlement Bank 694, andthe Contract Expiration Manager 360 comprises an integrated system, the“Order Management and Processing System 370 (OMPS).” The OMPS 370 is theengine supporting the front end application and provides all theautomated functions necessary for the execution of valid orders and thesettlement and payout of all contracts. The OMPS 370 accepts orders fromthe interface system and returns status information as the order isprocessed throughout the system. This processing system consists of thefollowing functions: validating orders, routing valid orders to theappropriate order matching engine, prioritizing orders, and matchingorders as appropriate. Every action taken on an order will be recordedto provide a clear audit trail of system activity and to ensure accurateclearing of all transactions. At different points in the processing, theOMPS 370 will communicate with the settlement bank or the clearingapplication, providing settlement instructions and periodicallyreconciling settlement bank records with OMPS records. In the preferredembodiment, the OMPS 370 is maintained on a UNIX platform and all loggedrecords will be time stamped accurately to the millisecond (the maximumprecision currently available within UNIX).

The Order Placement Application 310 is used by members to place andtrack orders for contracts and bundles. The trading system will onlyaccept limit orders (orders which require price and quantity to bespecified). The Order Placement Application 310 will allow members toperform the following activities:

-   -   place a new order to purchase or sell a contract;    -   place a new order to purchase or redeem a bundle;    -   cancel or change a pending order which has not either expired or        been executed;    -   track the status of an order;    -   view real-time the best bid and offer; and    -   view last trade price, trading volume, and trading history.

If it is an order to purchase or sell a bundle, the order is sent to theBundle Manager Application 345, which is responsible for bundle sale,redemption and expiration management. The Market Authority 500 standsready to sell and redeem bundles at a fixed price of $10. Suchtransactions will be executed by a fully automated system that will beoverseen by the market authority. The Bundle Manager Application 345will execute and allow the Market Authority 500 to monitor these typesof transactions.

Upon immediate acceptance by the Market Authority 500, an order topurchase or redeem a bundle is routed to the Settlement Bank 694 forsettlement and clearance. On the other hand, if the order is a limitorder to buy or sell a contract, then it is routed to Order Matcher 340,which places the order into a queue. The priority that the order assumesin the queue depends on the market trading rules, which takes intoaccount factors such as the time of order placement, price, and numberof contracts. When the Order Matcher 340 matches the order with asuitable counteroffer, and the order is first in the queue for orders ofits type, then the order is routed to the Settlement Bank 694 forsettlement and clearance. As described previously, several accounts aremaintained at the Settlement Bank 694, including Custodial Accounts 695a, which the market authority maintains for each of its members, theMarket Authority Account 695 b, which is a proprietary account thatholds all unencumbered funds owned by the Market Authority 500, and theSettlement Account 695 c, which is an escrow account that holds proceedsfrom the sale of bundles until the expiration of the contracts whichmake up that bundle and from which funds are taken to pay offin-the-money contracts.

At a time determined by contractually prespecified rules, contractsexpire. When a contract expires, either it is worth $10 or $0 dependingon the realization of the outcome of the underlying event. The ContractExpiration Manager 360 expires contracts and determines the finalliquidation value. Upon expiry, the Contract Expiration Manager 360notifies all holders of the contract. It halts trading by freezing theOrder Matcher 340 for that particular contract. If the contract expiresworthless, the Contract Expiration Manager 360 removes the expiredcontract from traders accounts. If the contract expires worth $10, theContract Expiration Manager 360 notifies the Settlement Bank 694 tocredit the account of the holder of each contract which is worth $10.

Before an order is processed by the OMPS 370, it must first bedesignated a legitimate order. The validation subsystem of the Validater320 will determine whether an order is legitimate by:

(i) making sure the member has permission to trade. Any member wishingto place an order must log in to the system by providing a valid ID andpassword combination. The validation subsystem will check the privilegesof the account from which the order originates to ensure that theaccount holder is (1) allowed to purchase the contract identified in theorder and (2) that the account holder is not already logged in to thesystem;

(ii) reviewing the order information to make sure it is complete andidentifying existing contracts or bundles that may be traded; and

(iii) optionally checking order originating account information toensure that the account has the necessary cash and/or contracts tofulfill the order. If it does, then the system blocks the appropriateassets so that the member cannot use these assets for a second order orother activities. As described below, this test may be delayed untilOrder Matcher 340 has determined a possible match.

If any of these tests are not satisfied, the validation subsystem of theValidater 320 will send a message to the Member 10 rejecting the orderand providing a brief explanation as to why the order was rejected. Ifall three tests are satisfied, then the order is validated, the statusof the order is updated to reflect validation, and the order istransmitted to the order routing subsystem. Simultaneously, the Member10 receives an order confirmation notice.

The Order Router 330 acts as a switch, directing orders received fromthe Validater 320, the Order Matcher 340 or other specific subsystems.If the order is for a contract (as opposed to a contract bundle), thenthe Order Router 330 directs the order to the order matching subsystemfor that particular contract. If the order is for purchase or redemptionof a bundle, then no order matching is necessary because this is adirect transaction with a fixed price of $10. Consequently, the OrderRouter 330 will send instructions to the Settlement Bank 694 or to theClearance and Settlement Application 690 to transfer fundsappropriately, and will simultaneously update the Market Authority 500and the member's accounts for the change in values of their portfolios.The Order Router 330 will also maintain and keep current a full audithistory for each order passed on by the Validater 320. It will provide(1) a status history recording every change in the state of an orderthus providing a complete system audit trail and (2) an executionhistory recording all executions made against an order. User accountswill be updated for all changes in the status of an order and historieswill be accessible for audit purposes.

There is an order matching subsystem within the Order Matcher 340 foreach contract traded on the Exchange. The order matching subsystem willmaintain a complete list of all bid and offer orders on a particularcontract (the order book). The orders in these order books will beprioritized first by price and second by the time the order was placed.All orders will be anonymous and the order matching subsystem will matchorders based only on price, quantity, order expiration time/date, andtime the order was placed. Each order matching subsystem will process anew order received from the order routing subsystem according to thefollowing standard price-time priority algorithm:

-   -   If the price of the new order is not better than or equal to the        best contra order listed in the order book, then the new order        will be added to the order book in a unique position reflecting        its price and time priority information;    -   If the price of the new order is better than or equal to the        best contra order listed in the order book, then the new order        will be matched against that contra order at the price of that        resting contra order;    -   If this does not fill the quantity of the new order, then the        subsystem will match the remainder of the new order with lower        priority contra orders in the order book until the quantity of        the new order has been satisfied or there are no orders        remaining on the contra side at a price equal to or better than        the price of the new order; and    -   Any remaining quantity after all possible executions have been        generated will be placed into the order book in the position        reflecting its price and time order placed priority.

Each order matching subsystem will process one order at a time topreserve order prioritization. One of ordinary skill in the art willappreciate that the above-described price-time priority algorithm, whilepreferred, is but one possible set of priority features and prioritiesand is provided by way of example and not by way of limitation.

As described above, in one embodiment of a system according to theprinciples of the present invention, each limit orders are validated byValidater 320 to ensure that the originator of the order has sufficientfunds or contracts to satisfy the order. If the assets are available,they are frozen until a transaction is completed or the order expires.This has the disadvantage of limiting the flexibility of a trader. Forexample, a trader may desire to acquire $10,000 worth of either of twoType I contract bundles A and B, with no preference for one bundle overthe other, except that she wants to execute whichever bundle first meetsthe terms of her order. Under the above-described embodiment of theinvention, when the purchaser submits an order for $10,000 worth ofcontract bundles A, validator 320 freezes $10,000 worth of funds in heraccount. However, unless she has an additional $10,000 on account,validator 320 will not validate an order for $10,000 worth of contractbundle B. Thus, the purchaser must select in advance one of the twocontract bundles to purchase. If the purchaser later decides to insteadpurchase the other bundle, the first order must be cancelled and a neworder submitted. This causes the order to be requeued and the purchaserloses her position in the price-time priority queue.

Alternatively, in a preferred embodiment of the present invention,validation of an order is delayed until Order Matcher 340 identifies apotential matching contra order. In this embodiment, when a potentialmatch is identified validator 320 ensures that the originators of eachorder has sufficient assets in their respective account to complete thetransaction. If the originators have sufficient assets, the transactionis completed as described above. If, however, an order originator failsto have adequate assets their order is cancelled and the match is notcompleted. A valid but unmatched order is returned to it respectivebuy/sell queue in the same position it had prior to the attempted match.In a preferred embodiment of the present invention, order originatorswhose orders are rejected because of insufficient assets when a match isattempted are charged a small fee. Such a fee may improve matching andsettlement efficiency because it provides an incentive for traders toensure they can satisfy their orders.

However, the delayed validation provides users with more flexibility.For example, the purchaser desiring to acquire $10,000 worth of eitherof contract bundles A or B may submit a limit order to purchase $10,000worth of contract bundle A and another limit order to purchase $10,000worth of contract bundle B—even if they have less than $20,000 onaccount. When one of the limit orders is satisfied, the originator maycancel the other limit order. Thus, the purchaser is able to acquirewhichever of the contract bundles first satisfied their respective limitorder.

Once an order is matched, it cannot be amended or canceled. However, ifit is still in the order book, the order matching subsystem will acceptcancellation and amendment instructions from the interface system. Ifthe order is amended, the order matching subsystem will treat it as anew order, and the new order will have a time priority corresponding towhen it was amended.

An order will be removed from the order matching subsystem if:

-   -   the order is matched with a contra order;    -   a the order is matched with a contra order, but it cannot be        validated;    -   the order is canceled by either the member who originated the        order or administrative staff in accordance with the rules of        the exchange;    -   the contract specified in the order expires before the order is        matched; or    -   the order expires by its terms before it is matched.

The member will be notified of any of these events, and all orderhistories will be updated to reflect the occurrence of any of theseevents.

Working with the order management subsystem, the Contract ExpirationManager 360 will record the change of ownership of all contracts tradedon the exchange. Upon expiration of a set of contracts, the ContractExpiration Manager 360 will accept instruction from the Market Authority500 as to which contracts are in-the-money, notify all owners of theexpiring contracts of the expiration, and credit member accounts in theamount of the value of the contract upon expiration (which is either $0or $10). Simultaneously, the Contract Expiration Manager 360 sendsinstructions to the Settlement Bank 694, identifying the accounts ofmembers holding contracts which expired in-the-money and directing theSettlement Bank 694 to transfer funds to those accounts.

The above description of an apparatus according to present inventionillustrates and describes a computer-based system in terms of functionalblock diagrams and website page structures. One of skill in the art willappreciate that once the desired functionality of the computer system isdefined (as has been outlined above), and/or the basic contents of theweb pages have been identified (as has been outlined above), the acts ofprogramming one or more computers or computer systems to perform thesefunctions is considered to be within the ordinary skill in the art forcomputer programmers. Moreover, while the above description of anapparatus according to present invention illustrates and describes acomputer-based system based on certain functional block diagrams andwebsite page structures where specific functionality is partitioned indiscrete portions, one of ordinary skill in the art will appreciate thatthe computer code may be partitioned and/or combined in differentdiscrete portions without changing the overall functionality of thesystem or departing from the spirit of the invention.

III. How Potential Registrants and Members Use the System

Thus far we have described some of the types of risk hedging contractswhich can be traded and have also described a preferred embodiment of anoverall system for offering, trading, redeeming and settling thesecontracts. Next, the method of the present invention in accordance withthe operation and function of a preferred embodiment of the inventionwill be described with reference to the figures. In the following,certain functions and processes of the system will be described, but thepresent invention is not limited to this set of functions and processesand some of the functions can be omitted or modified and other functionsand/or processes added without departing from the spirit of theinvention.

Registration Function

As noted above “Member” refers to a client who is registered with themarket. In addition to having trading and account privileges, memberswill be able to view the market, post and read messages using electronicmessage boards, and read news reports relating to the market, thecontract bundles and contracts, or the underlying measures.

In addition to its members, the Market Authority 500 will allow thegeneral public to access specific areas of the web site which aredesignated to be public and read descriptions of the exchange, revieworganization and rules, read the descriptions of contract bundles andcontracts, view the daily bid and offer prices and trading volumefigures for the various contracts, and, if they so elect, fill outmember applications. Non-members are prohibited from participating inthe market. Thus, non-members will not be allowed to purchase or sellinstruments or add messages to electronic bulletin board(s).

In the computer-based implementation of the present invention, to becomea Member 10, an applicant must access the Main Computer 100 through theInternet 200. As depicted in FIGS. B and C, the applicant can access theNew User Registration Page 450 from the Home Page 410. From there, theapplicant must follow the directions, read the information, print andfill out the necessary forms, and mail in the forms with his signatureand an initial deposit.

An applicant is required to certify in writing that he is (1) a citizenor permanent resident of the United States and (2) old enough to enterinto a legally enforceable contract. If the applicant is anorganization, it must reside in the United States and be validlyorganized, in good standing, and authorized by its charter to tradefutures contracts. Before being designated as a member, an applicantwill be required to read, and certify that they have read, the riskdisclosure document. Member applicants must also agree to be bound bythe site rules and to certify that they will only trade for themselvesor the company for whom they are registering and will not trade as anintermediary for others. Finally, in order to become a member, anapplicant will be required to open an account at the clearing agent. Theminimum initial deposit to open an account is a standard amount, forinstance $500.

After the Market Authority 500 approves an application for membership,the Market Authority 500 will: (1) assign the member an account number;(2) require the member to select a password; and (3) require the memberto select an identification code (“ID”) for use in conjunction withelectronic bulletin board and messaging system. In order to access theexchange, a member need only log onto the Internet 200, go via theInternet 200 to the website Home Page 410, and enter his or her accountnumber and password. Members will be prohibited from maintaining morethan one account. To police the one-account-per-member rule, the marketauthority will routinely scan its account database for identical names,telephone numbers, social security numbers, and other identifyingcharacteristics.

The contract rules allow the market authority to suspend or terminate,wholly or in-part, the privileges of members who violate the rules ofthe exchange in any way, including by supplying false information in anapplication for an account. Other grounds for suspension or terminationof member privileges will include trading for someone other thanthemselves or the company for whom they are registered to trade on themarket, behaving in a manner that affects the integrity of the market orits underlying systems, or any other reason necessary to protect themarket, its members, or the public.

Logon Process

In order to log into the system, a member or registrant must access theMain Computer 100 via the Internet 200. The member or registrant mustprovide a valid account number and initial password combination notalready logged onto the system. Members will be required to police theiraccount number, ID, and password to ensure that no one has improperlyaccessed their account. The Main Computer 100 system will record all logins and attempted log ins. If five consecutive failed log in attemptsare recorded for a particular account (due to incorrect password), thenthe appropriate software module working in cooperation with the WebServer Software 400 will automatically suspend that account. The WebServer Software 400 will then send an e-mail to the address registeredto that account informing the user of the account suspension and askingthe user to log into a uniquely generated reactivate account link. Uponsuccessful log in, the user will be required to select a new passwordfor the account and may change other aspects of his/her user profile(e.g., e-mail address).

Logout Process

For a user to close access to his account and the system, the user mustactively log out. To minimize the possibility of unauthorized access,the appropriate software working in cooperation with the Web ServerSoftware 400 can also log out a user if the system loses contact withthe user's computer or if the user is not active on the system (and doesnot respond to a system request) for more than an predetermined time,for instance 10 minutes. In this case, the user's session isautomatically “timed out”.

Account Set Up Process

After completing, signing, and mailing in the registration applicationtogether with some cash amount that is at least the required minimuminitial deposit of $500, the applicant must wait for formal approval ofhis application.

Once the Market Authority 500 approves a new user application, themember is notified by mail and Email, and the member is authorized tolog in to his account for the first time. Thereupon, the member isauthorized to access his account on the Main Computer 100 via theInternet 200. In the Log In Page 420 the member types in his user ID andinitial password. If the member successfully logs in, he will berequired to change his initial password by typing in (twice forconfirmation) a new password. The new password will be active each timehe logs in thereafter until he changes it.

When a new member logs in to his account for the first time, he will beasked to set up a personal home page. To this end, the member is offereda menu of items he can choose to include in his personal home page, andis asked to answer questions about the layout of those items on hispersonal page. Some of these items to be included are mandatory. Themandatory items include cash balance, the market value of the memberscontracts held in the account, and the per contract prices of each ofthe types of contracts in the member's portfolio. Other items arediscretionary. Discretionary menu items include a list of links toupdated information about contracts the member may be interested in,news headlines (general and specifically tailored), market indices,alert items concerning the market, links to bulletin boards, and otherlinks of interest.

Existing members may change the items and layout of their personal pagesat any time by clicking on a “change homepage” link.

Adding and Removing Funds from an Account

The first time a new member logs in, his account will have only hisinitial deposit, which is some amount at least $500. From time to time,members will want to either add or remove funds from their account.

Funds in member accounts as well as funds credited to the account of theMarket Authority 500 in payment for contracts will be credited to anaccount at a bank (i.e., the Settlement Bank 694). Members will bepermitted to fund their trading accounts by electronic check, wiretransfer, or other means. Funds will not be available for tradingpurposes in a member's account until the member's deposit has cleared.

A member may withdraw funds from the credit balance in his tradingaccount by making an appropriate request. On the same or the nextbusiness day following receipt of an appropriate request, the clearingagent will direct the Settlement Bank 694 to transmit the funds by checkor other means to the member. The funds will be withdrawn from theaccount of the Market Authority 500 within three business days of therequest, and will be electronically transmitted to a destination accountspecified by the member. In the event that a member attempts to withdrawfunds exceeding the available cash balance in his account (i.e., thecash in the account that is not blocked or otherwise set aside to covera pending purchase order), the request will be rejected and the memberwill be informed of the reason the request was rejected. To the extentthat the request is rejected because funds in the account are blocked,the member will be so informed and may unblock the funds by cancelingthe pending order for which the funds have been blocked.

View Market Data Process

The Executive Summary Page 436 summarizes the current activity on eachactively traded contract. The Executive Summary Page 436 may be accessedin many ways. As depicted in FIG. 4, the user has several alternate waysof accessing the Executive Summary Page 436 for each given contract.First, the user may simply go via the Internet 200 to the Home Page 410.From the Home Page 410, the user can go to the Underlying Info andContracts Page 430, select the contract link he is interested in, andclick on that to get an Executive Summary Page 436 of the marketactivity on that contract. Without logging in, however, the user cannotplace a trade in this contract.

Alternatively, the user can proceed from the Home Page 410 to the Log InPage 420. After logging in, he will see his Personal Home Page 422(i.e., My Account Page 422). From his Personal Home Page 422 (i.e., MyAccount Page 422), the user will either be able to directly access theExecutive Summary Page 436 (if he has chosen to include the link forthis contract on his Personal Home Page 422 (i.e., My Account Page422)), or he can access the Underlying Info and Contracts Page 430, fromwhich he can access the Executive Summary Page 436 pertaining to aparticular contract.

Order Placement and Execution

The site will be open for trading 24 hours a day, seven days a week.This continuous trading cycle avoids the need to develop rules forordering and executing member orders placed while the market is closed.The continuous trading cycle also avoids the need to develop rules forsetting opening prices and eliminates, by definition, the possibility ofa gap between closing and opening prices sometimes experienced ontraditional markets.

To access the market, the member will access the Internet 200, proceedto the website Home Page 410, enter his or her account number andpassword, and hyperlink to the trading page for the contract bundle andcontracts he or she wants to trade. Additionally, on the My Account Page422 the member will have access to his or her current account balanceand current open positions, and the page will provide the member with avariety of text, pull-down, and check boxes that the member can use topurchase or redeem a contract bundle or to enter an order to buy or sella contract.

To ensure equality of access to market information, all members will beable to view the size and price of the same number of recently executedtrades and the same number of outstanding bids and offers. At a minimum,all members will be able to view records of all trades executed withinthe last hour as well as a real time updated listing of the size andprice of the best outstanding bid and offer. Although all members willhave access to this market information when they enter an order, thisinformation may, of course, change between the time the member submitsan order and the time the market receives and processes it.

To place an order, the member proceeds to the Contract Description andOrder Form Page 440 (shown in FIG. 4). The only type of orders that thetrading system will accept will be limit orders, which are orders to buyor sell a specified number of contracts at a specified price or better.The member will be able to choose from the following different types oflimit orders:

-   -   Time Specified: A limit order with an expiration date designated        by the member, not to exceed a fixed time, for instance sixty        days, from the date the order is placed.    -   Immediate Or Cancel: A limit order that is to be executed in        whole or in part within a short time, for instance five minutes,        of being placed on the market, and any portion of the order not        executed within that time limit is cancelled.    -   All Or Nothing: A limit order that is to be executed only in        whole, and not in part, within the time period designated by the        member, not to exceed a predetermined time, for instance sixty        days, from the time the order is placed.    -   Cancel If Bettered: A limit order that is automatically        cancelled if the price bid or offered is not the best price for        the contract in the orders resting on the market.

In accordance with one embodiment of the invention, when a member placesan order to either buy a contract trading in the market or to buy a newcontract bundle, the Order Placement Application 310 (FIG. 7)automatically confirms that the member has sufficient funds in his orher account to execute the trade prior to adding the order to the orderbook. If the member has insufficient funds, the Order PlacementApplication 310 will inform the member of the shortfall and ask themember if he or she wants to execute the amount of the order that can besatisfied with existing funds. In accordance with the member's answer,the Order Placement Application 310 will either adjust the size of theorder or cancel it. To ensure that a member cannot place an order thathe or she does not have sufficient funds to cover, it is presentlyanticipated that the Order Placement Application 310 will permit onlylimit orders and not market orders. Additionally, funds from themember's account that would be needed to fill unexecuted limit orderswill be “blocked” when the order is accepted so that they are excludedfrom the funds the system uses to determine if the member has the fundsnecessary to place another buy order. If a member seeks to withdrawblocked funds from an account, the member will first be required tocancel pending orders sufficient to remove the block.

Alternatively, in accordance with another embodiment of the invention,confirmation that the member has sufficient funds to execute the tradeis delayed until a potentially matching contra order is found. Ifsufficient funds are on hand the transaction is consummated. Otherwisethe order having insufficient funds is cancelled and the other order isreturned to the applicable buy/sell queue. Preferably, the originator ofthe cancelled order is charged an appropriate fee.

Once the order is accepted, the member will be required to confirm it,and the order will then be placed in the order book. After an order isplaced in the order book, it will remain outstanding until the earliestof its execution, its cancellation by the member (or by in limitedcircumstances such as the termination of a series), the expiration ofthe time limit placed on the order by the member, for instance sixtydays, or the expiration of that contract series. A member may cancel anorder at any time prior to execution of the order by entering acancellation order, and if the order has not been executed before theOrder Placement Application 310 can withdraw it, the member will benotified that the order has been canceled.

All orders will be anonymous, and orders will be prioritized forexecution according to predetermined criteria. For instance, orders willbe prioritized for execution first by price and then by time, meaningthat the best bid or offer will have priority over all other bids oroffers, and bids or offers entered at the same price will be executed inthe order they were received by the system. If orders with the sameprice are received at exactly the same time (if such an occurrence istechnologically possible) one will be randomly assigned time priorityover the other using the minimum incremental unit of time in the system.

A newly entered bid that is higher than the best outstanding offer or anewly entered offer that is lower than the best outstanding bid will beexecuted at the price represented by the preexisting bid or offer to theextent that the size of the resting bid or offer is adequate to fill thenew order. If the order is only partially filled by the resting contraorder, then the remainder of the order will remain in the Order Book atits limit price and will execute against subsequently listed contraorders at its limit price.

After the Order Placement Application 310 confirms that the member hasthe finds necessary to buy a contract bundle or contract and executesthe buy order, the Order Placement Application 310 will, in the case ofa contract bundle purchase, open positions in one of each of thecontract bundle's contracts in the member's account and instruct theSettlement Bank 694 to debit $10 per contract bundle purchased from themember's account and to credit that money to the settlement fundsaccount. In the case of a contract purchase, the Order PlacementApplication 310 will open the contract position in the purchasingmember's account and close the position in the selling member's accountand will instruct the Settlement Bank 694 to debit the cost of thepurchase from the member's account and credit the value of the purchaseto the selling member's account. Trading fees will also be debited fromthe member's account and credited to an account at the Settlement Bank694.

When an order is executed, the member will be sent confirmation byelectronic mail. Upon execution of an order, the system will adjust theopen positions in the members' accounts and inform the settlement agent,which will make the necessary account adjustments. If for some reason amember wishes to dispute an order that he or she entered and confirmed,the member will be required to provide the confirmation number issuedwith the order and any subsequent confirmation numbers (such as acancellation confirmation number) associated with the order.

Two Ways to Establish the Same Position

A member can establish the same position in each contract in two ways.For instance, suppose the member wants to own one A contract. One way todo this is to place a limit order to buy one A contract. Then, when thatorder is settled, his desired position is realized.

But there is an alternative route the member can use to establish thesame position. He can (1) purchase a bundle that contains the Acontract; (2) put limit orders to sell every contract in that bundleEXCEPT the A contract. Then, upon execution of all his limit sellorders, the member will own exactly one A contract.

Trading Fees

The presently preferred embodiment contemplates that interest will bepaid to members based on the free cash balance in their accounts.However, the presently preferred embodiment does not presentlyanticipate paying interest on either funds paid to the Market Authorityfor the purchase of contract bundles, or on blocked cash balances (i.e.,balances blocked by the system because they would be needed to executeorders resting on the market). Income from investment of these funds, asdescribed in more detail below, will accrue to the benefit of the MarketAuthority. Thus, the foregone investment return on these fundsrepresents a cost to members of dealing in the exchange. The presentlypreferred embodiment also contemplates charging transaction fees fortransactions in contract bundles and contracts. The fee per trade willbe at least a minimum fee set by the market authority based on the costto market authority of processing a trade. The fee may be higher thanthe minimum fee based on the number of contract bundles purchased orredeemed or the number of contracts traded. Other fees, such as fees fororders cancelled because of insufficient funds, may also be assessed tousers of the system of the present invention.

Cancellation and Modification of Orders

Once an order is executed, it may not be cancelled or modified. However,members will be able to cancel or modify an order at any time before itis executed. All pending orders which a member has outstanding will belisted on the member's account page. To cancel or modify a pendingorder, the member will select the order to be changed and using prompts,either (1) cancel the order, (2) amend the order, or (3) leave the orderunchanged. If the member chooses to cancel the order and if the orderhas not been executed before the system can withdraw it, the member willbe notified that market authority has canceled the order. If the memberchooses to modify the pending order, the member will be shown thedetails of the existing order and be allowed to change any ordervariables (with the exception of the underlying event to which thecontract pertains). The member will also be informed that a modifiedorder will be treated by the order book as a new order, causing theorder to lose its original time priority.

Record Keeping and Retention

The Order Placement Application 310 will automatically record all ordersplaced on the market, and all trades executed, by date, time, quantity,contract bundle or contract type, underlying, price, expiration month,payout criterion, and member account number. In conjunction with theMarket Database 390, the Order Placement Application 310 will record allsettlements by time, amount, and member account number. The system willalso record by time all changes in the best bid or offer for a contract.

As noted above, the Market Database 390 is an electronic database fromwhich internal (nonpublic) market data, market data to be shown members,and publicly disseminated market data may be electronically retrievedand disseminated interactively. The internal market data preferablyincludes, but is not limited to, records of all orders, executions,cancellations, and other transactions entered into the Trade Engine 300,trading volume, changes in bids and offers for all contracts, andreports generated by the Market Authority 500. The market data to beshown members includes, but is not limited to, a list of (preferablyabout 5) recently executed orders, the best current and offer on themarket, and periodic trading volume updates. The publicly disseminatedmarket data, disseminated to vendors of market data and reported togovernment authorities, consists of a list of recent trades, tradevolumes, and the best bid and offers.

The system will transfer this information, and all other statisticalinformation gathered from its market, to a searchable database (i.e.,the Market Database 390) for retention for a predetermined period, forinstance a time of not less than five years. Using its database, thesystem will be able to reconstruct rapidly and accurately transactionsexecuted on the trading system and provide that information to the CFTCupon request. As part of its record retention program, market authoritywill also maintain for five years full records of all activityundertaken pursuant to its affirmative action program to securecompliance with the relevant provisions of Sections 5, 5a(a), 5b, 6(b),6b, 8a(7), 8a(9) and 8c of the CEA.

Trade Process—Split

A member does not have to do anything during a contract split. Themember's account is automatically updated and the split contract isreplaced with the new set of post-split contracts. The originalpre-split contract is no longer actively traded, so all existing limitorders on that contract are cancelled. The member is automaticallyauthorized to trade on the post-split contracts if he desires.

Trade Process—Combined Contracts

A member does not have to do anything during a contract combination. Ifthe member does not do anything, any entire set of contracts he ownsdesignated for recombination will be automatically combined. If he ownssome, but not all, of the contracts designated for recombination, thoseunmatched contracts will not be recombined and he is permitted tocontinue trading in those individual contracts as if there were norecombination. At expiry, those contracts will be settled as if therewere no recombination.

Redemption Process Details

As will be explained in the following, there are two kinds ofredemption: the redemption of bundles, and the redemption of contractsat expiry.

Complete bundles may be redeemed at any time. The Market Authority 500stands ready to purchase for $10 complete bundles at any time from anymember. To redeem a bundle, all the member does is submit the order onthe Contract Description and Order Page 440 (Illustrated on FIG. 4).Such redemption orders are executed instantly.

If the member places an order to redeem a contract bundle or to sell anexisting contract in the member's account, the Order PlacementApplication 310 will automatically confirm that the member has thenumber of contracts he or she wishes to redeem or sell and, if so,redeem the contract bundle or place the order on the market. If themember does not have the appropriate number of contracts, the tradingsystem will inform the member of the shortfall and ask the memberwhether he or she would like to redeem or sell all or a portion of thecontracts the member does have, or cancel the order. Based on themember's answer, the system will redeem or enter a sell orderrepresenting the correct number of contracts designated by the member,or cancel the order. A pending sell order will block the number ofcontracts subject to the order so that the same contracts cannot besubject to more than one pending sell order.

At expiry, contracts are settled automatically. By definition, everycontract is worth either $10 or $0 at expiry. If a contract is worth $10at expiry, the Contract Expiration Manager 360 (which is illustrated inFIG. 7) removes the contract and replaces it with $10 cash balance inthe member's account. If the contract is worth $0 at expiry, theContract Expiration Manager 360 simply removes the contract from themember's account.

IV. News, Bulletin Boards, Other Services

Another one of the innovations of the present system and methodaccording to the present invention is that such a system provides aone-stop information and “discount” brokerage service. As such, it canaggregate all relevant news, information, instruction, educational, anddiscount brokerage services on its website to stimulate the interest ofand communication between traders.

V. Hedge Market Account Card

A Hedge Market Account Card (“HMAC”) is an optional but preferredcomponent in a risk hedging market and system according to the presentinvention. The HMAC works like a bank debit card. A HMAC carriesinformation identifying the holder's trading account number and,together with a password that must be entered separately, allows thecardholder to access his account from portable machines. While the HMACis described as a “card” for the sake of illustration, in fact it can bea radio frequency tag, or any other type of indicator of identityincluding merely an account number to be entered on a keypad, orotherwise.

One use of the HMAC is to redeem tickets at box office. If the holdershows up at the concert with his card, swipes the card through a cardreader (also referred to hereinafter as a “point of sale terminal”) andenters a password, the reader (which can be connected to the Internet orto a computer directly connected to a suitable database) allows thecardholder to redeem the appropriate futures contracts in his accountfor concert tickets on the spot. The Market Authority electronicallydeducts the contracts from the holder's account, and issues tickets forthe concert.

One can imagine other related uses for the HMAC. For example, cardholders who don't have tickets could just show up at the box office withtheir card. They can use their card to log in to their hedging accountand bid for tickets that are still trading in the appropriate futuresmarket.

Another scenario is a “delivery on demand”. For instance, a futurescoupon for “a Spagos dinner in November” could have an “American” styleexpiration. The holder can get his meal any time during November bypresenting his HMAC at Spagos. Spagos would have a card reader to enablesettlement of the appropriate futures coupon.

“Member” refers to a client who is registered with the market. Inaddition to trading and account privileges, members will be able to viewthe market, post and read messages using electronic message boards, andread news reports relating to the market, the contract bundles andcontracts, or the underlying measures. Members will also have a HMAC.

While the HMAC has uses for all types of trading, the HMAC isparticularly useful for trading Type II (coupon) contracts, as describedabove.

The procedure for becoming a member is the same as that described abovein the Section pertaining to Type I contracts and the Market Authoritymails members who desire to trade coupons, a HMAC.

Regarding the adding and removing of funds from an account, in additionto the procedure described above for Type I contracts, members may beallowed to purchase a limited number of coupons using their credit card.

Regarding the view market data process, in addition to the proceduredescribed above for Type I contracts, the Market Authority and itspartners may provide special terminals for interfacing with the marketat the venues where coupons are redeemed.

In addition to the procedure described above for Type I contracts, theMarket Authority and its partners may provide special terminals forinterfacing with the market at the venues where coupons are redeemed.

Ticket Redemption

Many implementations of the HMAC are possible. Two examples are givenbelow.

In a first exemplary method, each box office has Internet-connected HMACreaders. HMAC holders may use these readers to redeem their futurescoupons for tickets in “real” time. However, HMAC holders may also domuch more via the card readers, including giving orders to place lastminute trades to buy additional coupons or to sell their unused coupons.

Every venue which uses the hedge market's services is equipped with thenHMAC card readers at its box office. The card readers are hooked up tothe hedge market's computers via a fast Internet connection, and theyalso have the ability to dispense tickets on demand (like how bankteller machines can issue cash). Coupon holders use these readers toredeem their tickets when they come to the concert (ball game, play,etc).

A card holder swipes his HMAC on the card reader and enters his secretPIN. The card holder is prompted to enters the number, N, of tickets hewould like to redeem. If the card holder has at least N of thecorresponding coupons in his account, the Market Authority automaticallysettles N of the coupons, and immediately issues N tickets to the cardholder.

If the cardholder has less than N redeemable coupons in his account, heis prompted to buy more coupons to make up the difference. Suppose thecardholder needs M additional coupons. Then he is told the best askprices in the market for M coupons, and is asked if he would like toplace a limit order to meet those asking prices.

If he says “yes” and there are sufficient funds in his account to makethe purchase, the M coupons are purchased, his final total of N couponsare redeemed, and N tickets are immediately issued. If he says “yes” buthis account lacks sufficient funds to purchase M coupons, he is giventhe option to purchase fewer than M, or to insert a credit card, fromwhich funds may be debited to cover the difference. In either case, theHMAC cardholder determines how many tickets he wants to redeem, pays oneway or the other, the necessary coupons are purchased and redeemed, andthe tickets are issued on the spot.

Any HMAC holder may, even if he starts with zero coupons in his account,purchase the necessary coupons and, therefore, buy N tickets—assumingthat there are enough tickets offered for sale in the limit sell queue.Towards the starting time of very high demand events like the SuperBowl, it could very well be that the limit sell queue is empty. If thelimit sell queue is empty, or it does not contain any asking prices theHMAC holder is willing to meet, the HMAC holder is prompted to enterlimit buy order(s), and to check back in a few minutes to see if hisorder(s) is(are) met.

If, on the other hand the HMAC card holder's account has extra couponsremaining in his account after redeeming his N tickets, he is promptedand asked to indicate if he wants to sell the remaining coupons in themarket. If it is near show time, the card holder will have no reason NOTto sell. If the card holder indicates he wants to sell, he is giveninformation on recent transaction and offer prices, and asked toindicate his asking price(s), and then the appropriate sell orders areplaced in the queue.

Coupons can continue trading as long as the tickets have any value.After the tickets lose value, the coupons themselves become worthlessand the Market Authority will automatically terminate the market. Thismeans the coupons market can continue trading even after the concertstarts, because latecomers may still want to buy tickets. However, afterthe concert ends, there is no point to trading the coupons (unless thepromoters have additional provisions for refunding unused tickets).

Alternative Redemption Method II

Method I demands a live Internet (or other speedy) connection to thecentral market databases. It may be that this connectivity is not alwayscost-effective. When that is the case, an alternative is to (a)pre-announce ahead of time that the Internet connected market stopstrading H hours before the concert (or play, game, etc); (b) H hoursbefore trading, freeze all Internet trading; and (c) the box officedownloads (via the Internet or private secure connection) the records ofall market information (including which account owns which position, andall the queue information) down to local computers.

With all the information downloaded into local computers, the theatrebox office can now handle all trading and redemption with localcomputers without having to communicate with the Market Authoritycomputers.

After downloading the market information, the theatre box office mayhandle redemptions in two alternative methods.

First, the box office may not support any additional coupon trading. Inthis case, it will simply allow HMAC card holders to redeem at the sitewhatever coupons the cardholder owns. Unredeemed coupons either expireworthless, or are refunded a pre-stated cash amount.

Alternatively, the box office computer may support a continuation ofmarket trading with the local (non-Internet connected) computers. Inthis case, the original limit bid/ask queues are still active. However,to place or cancel queue orders, an account owner MUST show up at thebox office with an HMAC card and use one of the local terminals.

HMAC card holders who show up at the box office may redeem theircoupons, or place trades in accordance with Steps 1-8 described inMethod #1 above. The only difference is the absence of an Internetconnection to allow offsite members to place or change their limitorders.

Compared to Method #2, the advantage of Method #1 is that it allows lastminute trading of coupons up to and during show time from anywhere inthe world, which benefits “scalpers” and speculators. Its disadvantageis that it encourages scalping and speculation, and the cost (to theMarket Authority) of Internet connectivity.

VI. Open Source

The present inventors are considering open sourcing the invention anddesign of new types of futures contracts to academics andindustry-specific experts as part of the inventive market implementationand operation.

In one implementation, the Market Authority would employ a personresponsible for managing the outsource developers. The outsourcedevelopers design the financial instruments (i.e., types of futurescontracts) in their own time, and submit their products to the MarketAuthority. The Market Authority retains the rights of final approval andacceptance. Submitters of approved and accepted instruments arecompensated by a fee and, possibly, a royalty arrangement on theirinstrument.

To stimulate the outsource development community, the Market Authoritymay sponsor and operate specialty conferences, mailing lists, tasklistings, Internet bulletin boards, and other forums where academics andother experts can discuss and debate their ideas. The Market Authoritymay also operate virtual chat rooms and appoint moderators to moderatethe forums and ultimately oversee the finished system.

Product Design.

A working list of candidate contracts can be published on a web site bythe Market Authority for contract developers. Comments and input can besolicited from the general public about candidate contracts on thislist. The Market Authority can take into account public comments beforeselecting contracts from this list for trading. The Market Authority maydevelop a more granular design process along the lines of an N-stepprocess that all products go through before they are marketed to thegeneral public.

Benefits of Open Source

Open Source gives the Market Authority direct access to a wideintellectual talent pool. By collectively harnessing the intellectualresources of a wider pool of academics, Open Source will generate greatideas that a small group of employees couldn't possibly imagine,regardless of how smart they are.

The Market Authority can immediately get involvement from the corporateexperts in the Industry. These corporate experts better understand theircompany's risk management needs than external experts.

Open Source provides the Market Authority with visibility andcredibility, which from a marketing perspective is impressive. There ispotential for a viral contagion effect to some degree, and it gives theMarket Authority which exploits Open Source, the potential for anevangelical advantage (like Linux).

Open Source is likely less expensive than hiring internal experts.

Open Source leverages the power of the Internet.

Open Source lends cache, public identification and awareness, andmomentum, and hence creates a greater barrier to entry for a marketdeveloper who does not use Open Source.

In summary, Open Source in our financial context is loosely analogous tothe development of Linux in the software context. The U.S. has severalthousand universities, and most of them have an economics and/or financedepartment. The relevant academics and their graduate students arerelatively easy to identify and contact to be the first Open Sourcecontributors.

VII. Variable Payout Hedging Contracts

In addition to the foregoing Type I, Type II and Type III contractsother types of risk hedging instruments may be defined, each of whichintroduces unique, novel and valuable methods which are considered partof the present invention. Moreover, in addition to the general purposecomputer based system described in the foregoing, it will be apparent toones of ordinary skill in the art that the novel aspects of the riskhedging approaches will imply specific and novel apparatus attributes insystems which are used to buy, sell, trade, and redeem theseinstruments. Accordingly, the following discussion addresses both novelmethods of hedging risk and making or administering a market for thehedging of risk but also novel systems and apparatus for facilitatingthe same.

The underlying contracts consist of the following:

(i) Fixed Pay-Out Hedging instrument: An binary contract that is worth$0 if the value or range of values represented by the Hedging instrumenthas not occurred by or on the expiration date and a fixed amount, e.g.,$10, if the value or range of values represented by the Hedginginstrument has occurred by or on the expiration date.

(ii) Variable Pay-Out Hedging instrument: An contract that is wortheither $0 if the value or range of values represented by the Hedginginstrument has not occurred by or on the expiration date, or anin-the-money amount that is set based on the degree to which the valueor range of values represented by the Hedging instrument has occurred byor on the expiration date. Optionally, the value of the instrument maybe capped.

(iii) Hedging instrument Bundle: A group of fixed or variable pay-outhedging instruments, each of which represent a mutually exclusive rangeof values of the underlying measure and which collectively representall, or just some, of the possible values of the underlying measure.

Variable Pay-Out Hedging Instruments

Variable Pay-Out Hedging instrument: A contract that provides thein-the-money contract holder with a payment up to a capped maximumamount, and requires the out-of-the-money contract holder to pay up tothat same capped maximum amount, depending on the value or range ofvalues of the underlying by or on the expiration date.

A Market Authority can offer a Variable Pay-Out Hedging instrument onany measure with any fixed number point range. For example, a MarketAuthority may offer a Variable Pay-Out Hedging instrument on the XYZbroad-based index futures with a 100 point range from 1950-2050. Thebuyer of the instrument (the “long”) is entitled to receive, and theseller (the “short”) is required to pay, $1 (or a multiple of $1) forevery point the index gains above the index level at which the partiesentered into the contract, and the buyer is obligated to pay, and theseller is entitled to receive, $1 (or a multiple of $1) for every pointthe index drops below the index level at which the parties entered intothe contract.

Depending on the rules of the trading market, trading a variable pay-outinstrument may require Blocked Funds, or other collateral, equal to thebuyer's or seller's maximum potential loss per contract times the numberof contracts traded plus any applicable trading, origination, clearing,and settlement fees and commissions.

For a buyer, the profit or loss is:(Ending Price−Purchase Price)*(# of contracts)The maximum potential loss is simply the loss caused when the finalvalue of the index is less than or equal to the lower bound of thetrading range, i.e, (Purchase Price-Lower Bound). If, a trader in theexample above wishes to purchase 10 contracts at 1985 the maximumpotential loss is:(1985−1950)*(10)=$350.00,The blocked funds are used to cover any loss including a loss up to themaximum possible loss. If, on the other hand, the markets rally and theupper bound is breached, the trader would realize a maximum profit of:(2050−1985)*(10)=$650.and the $350 of Blocked Funds would also be returned to the trader.

At any point before the halt of trading the trader can liquidate theposition by finding another exchange member to assume the trader'sobligations in the open market. If, for instance, the long closes itsposition by selling that position on the open market at 2007, his profitwould be:(2007−1985)*(10)=$220 profitsand the $350 of Blocked Funds would also be returned to the trader.

The position of the seller is the mirror-image of the position of thebuyer. Selling this instrument short requires a blockage of funds equalto the seller's maximum potential loss per contract times the number ofcontracts traded plus any applicable trading, origination, clearing, andsettlement fees and commissions. Maximum potential loss is simply (UpperBound-Selling Price). If, for instance, a trader wishes to short 10contracts in the above example at 1985, the maximum potential loss is:(2050−1985)*(10)=$650.00If, on the other hand, the XYZ Index trended down, the trader couldrealize a maximum profit of:(1985−1950)*(10)=$350.00 profit

At any point before the halt of trading, the trader can liquidate theposition by finding another exchange member to assume the trader'sobligations in the open market. If, for instance, the short closes itsposition for a loss by buying back that position on the open market at2007, his loss would be:(1985−2007)*(10)=$220which would be covered by the blocked funds, and the remaining $430 ofthe blocked funds would be returned to the trader.

Futures contracts designed in this way would preserve an essentialfeature of the Hedging instrument in that a Market Authority would notneed to manage risk—the market is always fully-funded or collateralized(i.e. no margin). That is, the Market Authority would be guaranteed tohold the maximum amount that it would be obligated to pay out tocustomers on the contracts.

To ensure that the market is always funded, trading in variable pay-outhedging instrument is halted if the index level goes outside the tradingrange set in the contract. For example, the trading of the XYZ indexfutures described above would be halted if the index moved outside ofthe range 1950 to 2050. In accordance with a first embodiment of avariable pay-out hedging instrument, trading is permanently halted whenthe upper or lower limit is first breached. In an alternativeembodiment, trading is only halted so long as the underlying measure,e.g., the XYZ index, is outside of the specified range and trading mayrecommence if the underlying measure comes back into the allowed rangeprior to the expiration of the contracts.

It is anticipated that these variable pay-out contracts should be deemedto be futures on a broad-based index and therefore within the exclusivejurisdiction of the CFTC. The contract would behave economically like astandard exchange-traded future between the cap and the floor. Adding anupper and lower limit to the future would not make it any less a future.This analysis is bolstered by the fact that futures currently havelimits in that exchanges impose daily price limits on some futurescontracts, and every futures contract has a lower limit in that theprice of the underlying commodity cannot go below zero.

A difference between the Variable Pay-Out Hedging instrument and astandard future is that the maximum loss is paid in by the buyer andseller up front and the contract thereafter is not subject to daily“variation” or “market to market” payments. However, the amount paid inis not a “premium” that is paid by one side and earned by the other asin the case of an option. In the case of an option that is written atthe money, if the value of the underlying measure has not moved atexpiration, the option will expire worthless and the writer will keepthe premium. On the other hand, if the variable pay-out contractdescribed above is filled at the current market value of the underlyingmeasure and the market does not move, neither side will experience anygain or loss. It thus behaves like a future rather than an option. Thefact that the maximum loss is paid in up front is a purely mechanicalmatter of how the risk is managed rather than any fundamental differencethat should affect jurisdiction.

Example 1 Variable Pay-Out Contract for a Broad-Based Index Future

Suppose a buyer and seller enter into a contract based on the XYZ stockindex (a broad-based index), whose current level is 8500. Under theterms of the contract, the purchaser (the “long”) is entitled toreceive, and the seller (the “short”) agrees to pay, $1 for every pointthe index rises above 8500; and the long agrees to pay, and the short isentitled to receive, $1 for every point the index falls below 8500. Theupside and downside are both capped at 1000 points, i.e., the long willreceive nothing more once the index passes 9500, and the short willreceive nothing more once the index goes below 7500. Both the long andthe short are required to deposit $1000 (each party's maximum exposureunder the contract) with the Market Authority at the time they enterinto the contract, and neither party can withdraw any portion of itsdeposit until the contract expires and each party's total gain or lossis known. Futures contracts designed in this way would preserve anessential feature of the Hedging instrument in that a Market Authoritywould not need to manage risk because it would always be certain to holdthe maximum amount that it would be obligated to pay out to customers onthe contracts.

Example 2

Suppose that a Market Authority offers a variable pay-out hedginginstrument based on the NASDAQ called something similar to:

-   -   8 Apr. 2004 NASDAQ Linear 1950-2050

This name denotes that, within the range 1950 to 2050, a buyer thatpurchases a contract gains $1 for every point the NASDAQ futures closesabove the purchase price and loses $1 for every point the NASDAQ futurescloses below the purchase price. If the market breaches either side ofthe range (i.e. ticks <1950 or >2050) trading is immediately halted forthe remainder of the instrument's duration. In our example, the NASDAQfutures close refers to 4 p.m. ET on 8 Apr. 2004.

Purchasing this instrument requires a blockage of funds equal to thebuyer's maximum potential loss times the number of shares traded plusany applicable trade and settlement charges, or:((Purchase Price−Lower Bound)+Trade/Settlement Charges)*(# of contracts)Maximum potential loss is simply (Purchase Price-Lower Bound). If, forinstance, trade charges are $0.25 per contract and a trader wishes topurchase 10 contracts at 1985, then blocked funds would be:((1985−1950)+0.50)*(10)=$355.00Where, the $0.50 refers to a $0.25 trading fees and a $0.25 settlementfee.

Profit or loss would simply be:(Ending Price−Purchase Price)*(# of contracts)And the trader could realize a maximum profit of:(2050−1985)*(10)=$650,or a maximum loss of:(1950−1985)*(10)=$350.00.

As described above, trading of the variable pay-out contract is haltedwhen trading is outside of the specified range. However, at any pointbefore settlement day a trader may liquidate their position. If, forinstance, a trader decides to take profits with the NASDAQ futurestrading above the upper limit at 2007, their profit would be:(2007−1985)*(10)=$220,and the $355 in blocked funds would also be returned to the user, lesstrade and settlement charges, e.g., $5.

The details of selling are analogous to the buying details describedabove. Interestingly, short-selling can be handled just as easily aslong-selling. Suppose, in the example above, that a trader wished tosell short 10 contracts at 1985:((2050−1985)+0.50))*(10)=$655.00,would be blocked. The maximum loss would be:(1985−2050)*(10)=$650which would be covered by the blocked funds. Similarly, the maximumprofit is:(1985−1950)*(10)=$350.00 profit,and the $655 in Blocked Funds would also be returned to the user, lesstrade and settlement charges.

As described above, a trader can liquidate their position any timebefore settlement. If for instance the trader decides to take a losswith the NASDAQ futures trading 2007 (more than the upper limit), theloss would be:(1985−2007)*(10)=$220 losswhich would be covered by the $655 Blocked Funds, and the remainder,less trade and settlement charges, would be returned to the user.

The preceding examples show the viability of a linear Hedging instrumentmodel for buying, selling, and selling short. The YES/NO concept hasbeen removed. Variable profits/losses have been achieved while keepingthe market fully-funded or capitallized (i.e. no margin) at all times.

The illustrative examples provided above use $1 per point at theincremental value of the variable pay-out instrument. However, thisamount may be changed as needed, depending on how wide a range isdesired. As a general matter, depending on where the market is inrelation to the range (or how wide the range is), the amount of BlockedFunds may be prohibitively high for some traders to take a (large)position. This is simply the nature of sequestering the maximum possibleloss to insure a Market Authority remains totally neutral. Preferrably,modeling is used to adjust the incremental value so as to maximize theprofit of the Market Authority given the P&L/point, tradecharges/contract traded, width of range, volatility of underlying, etc.

Given the calculations needed to determine the amount of blocked fundsneeded for a transaction, it may not be intuitive how many contracts auser can purchase using their Available Cash. Accordingly, someindication is preferrably provided in the form of an informative errormessage when a user is unable to purchase the number of contractsdesired. For example, a message or dialog such as “You are able to buy xcontracts with the amount of funds you have available. Click here tolearn more” may be provided. The link would lead to an explanation ofwhy funds equal to the user's maximum potential loss need to beavailable.

As described above, trading of an instrument must halt immediately ifthe range is broken. This is to keep the profits to be paid out plustrade charges within the total amount a Market Authority has blockedfrom the various user accounts. An instrument may be designed to‘expire’ if a limit is breached, or to remain available for a resumptionof trading if the contract price falls back into the permitted range.

Even though hourly or similar “next tick” type contracts may be frownedupon, it may be possible to offer Daily contracts that approximate theadrenaline-rush of shorter duration contracts. For example, if theNASDAQ closed today at 1975, a NASDAQ Linear 1970-1980 could be offeredthe following morning that expires at the end of the trading day. Givenany sort of volatility, the NASDAQ will breach one of the barriers wellbefore the end of the day. Once this contract has been halted, anothercontract could almost immediately be offered based on the breached limitof the earlier contract, e.g., a NASDAQ Linear 1980-1990 could beoffered if the upper limit of 1980 were breached.

Alternatively, the following morning several NASDAQ Linear contractscould be offered at abutting, or overlaping ranges. For example, NASDQLinear contracts with ranges of 1960-1970, 1970-1980, and 1980-1990,could be offered. Initially, only one of the contracts will be availablefor trading. However, as the NASDAQ moves it may pass the limit of onecontract and enter the trading range of another contract. Launchingnarrow-range contracts could provide for a fast-paced, lower stakes(tight stop-loss) opportunity for traders. Another possible option is acontract that has an acceleration feature (i.e., the expiration date isaccelerated if the contract breaches the range—like a capped option).

Some users will be tying up a significant amount of available cash toget into these contracts. If such contracts are offered, users willlikely settlement to occur as soon as possible after liquidation so thatBlocked Funds may be unblocked (and would probably ideally like torealize their profits) before the end of day settlement mi. This wouldenable them to continue trading. Accordingly, in a preferred embodimentof the present invention, settlement is performed continuously. Forcontracts in which trading is permanently halted due to a limit breach,users' positions are frozen when a breach occurs and any blocked fundsof in the money contracts are released for further trading.

In the foregoing, several types of hedging instruments were described,each of which suggests a novel method for hedging certain types of riskas well as suggests a novel system and market for trading in riskinstruments to facilitate hedging of risk.

In addition to the foregoing hedging instruments, the present inventorshave also conceived of additional hedging instruments each of whichsuggest still further novel methods for hedging certain types of risk aswell as suggests novel systems and markets for trading in riskinstruments to facilitate hedging of risk.

Although it would not be considered obvious to one of ordinary skill inthe art to conceive of the following hedging constructs, once the typeof hedging instrument is defined, as is provided below, one of ordinaryskill in the art would appreciate how to make, use and practice themethod of risk hedging enabled by these instruments in view of the otherdisclosure in the present application. Additionally, one of ordinaryskill in the art, based on the other disclosures in the presentapplication, would appreciate how to make a system for facilitating thetrading in these instruments.

The Corporate Earnings Hedging instruments are designed to allow tradersto take a view on a company's reported earnings per share (EPS) for aparticular quarter. As specified in the instrument itself, these Hedginginstruments will be settled based on a company's GAAP EPS as announcedor as reported to the SEC as part of their quarterly filings.

Accounting metrics are designed to allow traders to take a view onfigures and metrics listed on financial statements for a particularperiod of time. These Hedging instruments will be settled based onfigures published in the accounting statements as part of theirquarterly filings. These include numbers like sales, interest,depreciation, inventory, reserves as well as key business ratios likegross margin, net margins and operating margins.

Trigger Event Hedglets are designed to allow traders to take a view onif a trigger event occurs that may allow parties to exercise or escapefrom contractual obligations with a company or group of companies. Theseinclude instruments that are based around trigger events whether theycome about as the result of a specific cash flow figure being reported,a key financial ratio being breached, a debt or loan being restructuredor defaulted on, as the result of changes in ownership control or thecapital structure.

Corporate Statistics Hedging instruments encompass a wide variety ofHedging instruments based on figures companies officially release to thepublic as part of their financial statements. Examples include Hedginginstruments based on: Wal-Mart's Same-Store-Sales statistics, Intel'sCapital Expenditure's Number, General Motors Sales Volumes, Schwab'snumber of accounts, eBay's number of auctions and any announcementsregarding key business statistics etc.

M&A Hedging instruments allow traders to take a position with regard towhich companies will publicly announce their intentions to merge.Additional Hedging instruments settling based an announced merger ortender offer being completed or accepted by a particular date.

IPO Hedging instruments enable traders to take a position that a privatecompany will offer shares to the public by a certain date. A relatedclass of Hedging instruments would allow a trader to take a view on acompany's market capitalization as of a specified future date.

Bankruptcy Hedging instruments are designed to enable traders to take aposition on whether a company will file for relief under Chapter 7 orChapter 11 of the US Bankruptcy Code by a particular date.

Index Listing/Delisting Hedging instruments enable traders to take aposition on whether a particular company is part of a widely followedindex (e.g. the DOW, S&P 500, Nasdaq 100, etc) on a given future date.Traders would be empowered to take the position that a company not partof the index will be added by a certain date. Alternatively, traderscould take the position that a company currently part of an index willbe removed by a given date.

Exchange Delisting Hedging instruments allow traders to take theposition that, by a certain future date, a particular company will nolonger be listed for trading on a specified exchange.

Credit Ratings Hedging instruments enable traders to take a viewregarding the ratings a particular company will maintain from a givenCredit Rating Institution (e.g. S&P, Moody's, etc) on a set future date.Related Hedging instruments allow traders to take a view regardingcredit rating revisions by a certain date.

Management Team/Board Member Hedging instruments are designed to lettraders take a view regarding the composition of a company's Board orManagement/Executive team on a given date. Traders will have theopportunity to take positions regarding both additions and removals fromthe groups as well as CEO votes of no confidence.

Dividend Hedging instruments allow traders to take a view as to howlarge a corporation's dividend payout will be for a certain timeinterval.

Shareholder Actions Hedging instruments are designed to allow traders totake a position on any number of proposals that shareholders put to aformal vote.

Capital Change Hedging instruments are designed to allow traders to takea view on the results of announced changes in the capital structures ofcompanies as reported to the SEC as part of their quarterly filings.These include increases and reductions in capital through stocksplits/subdivisions, reverse splits/consolidations, write-ups andwrite-offs, bonus issues, rights issues, and transformation of new linesinto or out of the parent security. An example would be the announcementof the listing of a tracking stock.

Income and Principal Payment Events are designed to allow traders totake a view on the results of debt instrument changes such as changes incoupon, and principal payment amounts, changes in fixed and floatingcoupon rate resets, and early calls for bond redemptions.

1. A computer-based contract trading system for formation, sale, resaleand settlement of variable pay-out hedging contracts under jurisdictionof a government regulatory agency, the system comprising: acommunications interface for sending and receiving data, includingtrading instructions from traders; a processor system for executingprocessing modules; a first processing module for receiving data todefine a desired contract having a value at a time of maturitydetermined by a difference between a value of a predefined indicator atthe time of maturing and a target value selected at contract formation;a second processing module, responsive to said first processing module,for defining a contract based on said received data; a third processingmodule for offering for sale and for selling a plurality of saidcontracts to traders; a fourth processing module for accepting orders totrade one or more of said contracts; a fifth processing module fordetermining whether an originator of an order to trade one or more ofsaid contracts is able to perform the order; a sixth processing modulefor matching an order to sell said contracts with orders to purchasesaid contracts; a seventh processing module for settling contracts atmaturity thereof; and wherein said system retains transactioninformation for compliance with regulations of the government agency. 2.The computer-based contract trading system in accordance with claim 1,wherein the fifth processing module makes the determination when anorder is submitted to the computer-based contract trading system.
 3. Thecomputer-based contract trading system in accordance with claim 2,wherein assets of an originator of an order are frozen at the time thedetermination is made so as to ensure the assets are available tosatisfy the order should it be matched with a corresponding order by thesixth processing module.
 4. The computer-based contract trading systemin accordance with claim 3, wherein the difference between the value ofa predefined indicator and the target value are capped and the assetsfrozen such that their value is equal to a maximum exposure determinedby said capped difference.
 5. The computer-based contract trading systemin accordance with claim 1, wherein the fifth processing module makesthe determination when the sixth processing module has identified apossible match between an order to sell a contract and an order to buy acontract.
 6. The computer-based contract trading system in accordancewith claim 5, wherein the sixth processing module submits matched ordersto buy and sell said contracts to the seventh processing moduleresponsive to the determination of the fifth processing module.
 7. Thecomputer-based contract trading system in accordance with claim 6,wherein the sixth processing module cancels orders if the fifthprocessing module determines that an originator of the order does nothave sufficient assets to complete the order.
 8. The computer-basedcontract trading system in accordance with claim 5, wherein theoriginator of an order canceled because of insufficient assets ischarged a penalty.